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Fractal Spikes and Global Competition

In my last blog posting, I mentioned the increasing value of place.  At a time when information technology is supposed to make location irrelevant, we need to wrestle with the paradox that location is becoming more, rather than less, important. In fact, place is becoming an ever more critical dimension of competition in global markets. Executives who dismiss the value of place are likely to find themselves marginalized.

Microclusters

In this context, Steve Lohr wrote a fascinating article in the New York Times on December 20 entitled "Silicon Valley Shaped by Technology and Traffic" making the case that Silicon Valley actually consists of multiple “microclusters”.  Geographically, the microclusters array as follows:

While there are plenty of exceptions, it is generally true that hardware clusters – semiconductors, disk drives and network equipment, for example – are in the South Valley, around San Jose and Santa Clara. . . . . Moving farther north in the Valley typically means moving farther away from the guts of the machine and climbing up the tiers of computing – from chips and layers of business and consumer software and then into San Francisco, home to people with online advertising and digital design skills.

Lohr might have also mentioned emerging microclusters around biotech in South San Francisco and nanotech in the Menlo Park/Palo Alto area.

These microclusters are defined by skills, but they also generate cultural friction as well.  Lohr writes:

There is a certain visual identity to the clusters, and a hint of cultural tension among them. The clearest schism, perhaps, separates Valley dwellers from San Francisco residents.

The hard core in the Valley jokes that San Francisco, with its Internet advertising and design cluster, has a “high P.I.B. coefficient,” for People in Black.  The city’s companies also have more women than those in the Valley.  San Franciscans regard Valley engineers as denizens of a style-free suburban zone for whom being well-dressed means wearing jeans and a T-shirt with a company logo.

Marc Andreesen, co-founder of three Silicon Valley companies, sums up the culture clash best with this quote from the article:

“ . . . in general, the nerds with minimal social lives like me are well down in the Valley, and the cool kids with the trendy glasses and Prada shoes who like to go to parties are in San Francisco.  You can guess who has the leg up in building companies.”

Some companies like Google need to access talent from multiple microclusters, leading to solutions like Google’s 32 shuttle buses that help ease the commute to its campus for some 1,000+ employees.  There is no word about the culture clashes that surface as the buses from San Francisco discharge their people in black on campus (perhaps they don camouflage before boarding the buses).

(For the record, I live in the mid-Peninsula area, close enough to drop in on the cool San Francisco parties, but far enough away to get some serious work done.)

Why Place Matters

Lohr’s article provides compelling evidence that geographic proximity still matters, even down to the neighborhood level, even in the most technologically sophisticated talent pool in the US.  Why is this the case?

It is all about talent development.  No matter how talented any of us are these days, our talents must be continually and quickly refreshed and augmented if we are to thrive in this rapidly changing global economy.

The best way to refresh and augment talent is not to attend some training course.  In this fast-moving world, by the time knowledge has been expressed and packaged in a form that can be used in a training course, it is probably out of date. We all need to find ways to connect with people who are at the leading edge of relevant talent pools. 

The most valuable knowledge these people have is tacit knowledge – especially the knowledge that is so new that they have difficulty in articulating it, much less abstracting and codifying it. This is a key point for business strategy – when the pace of change accelerates, the balance of value between explicit knowledge and tacit knowledge shifts profoundly. Strategies focused on developing and protecting explicit knowledge fall when confronted with effective strategies to tap into and leverage tacit knowledge.

This is exactly why talent spikes become so strategically important in times of rapid change.  They provide rich opportunities to connect with people at the leading edge of relevant talent pools and more effectively access the tacit knowledge that is so valuable. These connections can take many different forms.  It starts with the casual encounter at the soccer game as described by Steve Lohr in his article. It could be connections that are made possible by a rich infrastructure of specialized service providers, including financers, lawyers, marketing firms or even real estate firms.  One of the key roles of good venture capitalists is to serve as a talent hub, making introductions helpful to their entrepreneurs in accessing relevant talent.

These connections can be very helpful in terms of exposing someone to a new idea or story that sparks some creative insight.  For many, including myself, it is about the patterns that emerge from countless encounters and conversations.

But the true richness of talent spikes comes from the opportunity they provide to engage in real work with other people who are at the leading edge of their fields.  It is one thing to have a casual conversation at a party or even a business meeting.  It is a completely different thing to engage in a challenging work project where all the participants are pushing their skills to the limit and learning deeply from the experience and expertise of others.  It is here that tacit knowledge becomes the most visible and accessible. JSB and Paul Duguid did a masterful job of highlighting this role of talent spikes in their essays “Mysteries of the Region: Knowledge Dynamics in Silicon Valley” and "Local Knowledge: Innovation in the Networked Age."

Talent spikes differ in terms of their ability to provide this opportunity.  Annalee Saxenian, in her historic work, Regional Advantage, captured the advantage of Silicon Valley relative to Route 128 outside Boston as a high tech talent spike precisely in these terms.  In the Route 128 corridor tech companies tended to operate as self-contained and relatively secretive entities with limited flows of employees across enterprise boundaries.  Silicon Valley companies in contrast were much more prone to collaborate with other companies. Among employees, rapid changing of employers became a badge of honor.  Staying too long with one company was viewed with some suspicion. The opportunity to engage deeply with diverse collaborators and access tacit knowledge was far greater in Silicon Valley. 

Silicon Valley further enhanced this advantage by emerging as a more effective global talent magnet, attracting skilled and entrepreneurial engineers from around the world. People often overlook this aspect of Silicon Valley in seeking to uncover the “secret sauce” driving SV’s success, yet it has been central to the innovation that has been a hallmark of this talent magnet.  The ability to attract and retain talent from around the world drives the continuing success of Silicon Valley.  Current patterns of talent flows have been impressively documented in Joint Venture Silicon Valley Network’s Index of Silicon Valley 2007. Its report notes that “Silicon Valley’s population is increasingly more global in character than in California or the U.S.”

A New Basis for Competition

Now, as we move into the 21st century, a new dynamic is beginning to play out.  As captured by Annalee Saxenian in her more recent book, The New Argonauts: Regional Advantage in a Global Economy, Silicon Valley capitalized on globalization to build a rich network of personal and institutional connections with emerging talent spikes in Israel, Taiwan, China and India.  In many cases, these connections arise as successful entrepreneurs in Silicon Valley who came here from abroad return to their home countries to participate in local spikes.

Saxenian does a great job of describing the connections that are emerging and evolving across these talent spikes but, from my perspective, this is just the first step in the next wave of global competition.  We need some profound institutional innovation to more effectively harness the capabilities that are developing in spikes around the world. 

On this dimension, I fear that Silicon Valley companies are falling behind more innovative Asian companies. A number of Asian companies are mastering the management techniques and institutional architectures of process networks required to access and mobilize talent across hundreds or thousands of business partners on a global scale.  While many Silicon Valley companies participate in process networks, very few have successfully organized and orchestrated these process networks.

The Bottom Line

Place still matters in shaping talent development and competition. Place matters because density matters. Density increases opportunities for serendipitous encounters and sustained and rich collaboration. Place not only matters; it is becoming even more important and much more complex. 

Depending on whether you zoom in or zoom out, relevant spikes emerge at the neighborhood, metropolitan or global level.  In fact, they are fractal, down to the level of corridors and work areas within specific buildings. Some companies have developed explicit location strategies, seeking to locate facilities in key spikes in an effort to attract local talent.  Far fewer companies have successfully tackled the challenges of effectively connecting talent across geographic spikes in ways that accelerate learning and talent development.  Technology tools can help support these efforts, but the real opportunity is to define new environments that foster productive friction on a global scale. In a flat world, where you stand really does matter.

Restoring Balance in the New Year

A new year is upon us and it is time to make those resolutions, promising ourselves that we will do better this year.

In keeping with this time-honored tradition, let me start with a firm resolution to up my game on this blog.  Over the past six months, my postings have tended to be few and far between.  I have been consumed with the challenge and excitement of building a new research center for Deloitte & Touche USA LLP here in Silicon Valley.  We are now up and running (well, at least walking quickly but still in stealth mode) so I feel comfortable devoting a little more time and attention to these postings. Of course, I continue to be hampered by my inability to master the art of the pithy blog posting – once I get started on one of these, it is really hard to stop.

This posting won’t be any different. In the spirit of New Year’s resolutions, I’d like to offer a set of resolutions regarding some of the themes that I want to explore in the year ahead.  Many of these resolutions offer a contrarian take on some of the conventional wisdom floating around these days, especially in the Internet world.  Without revealing too much (at least not yet), this posting will offer a preview of some of the perspectives that will shape this blog over the next year.

I will explore the growing value of stability.  As I venture into the dot com corridors of Silicon Valley these days, I get more than a whiff of those heady days in the late 1990s when all moorings were cast aside and we plunged into the strong currents of change, celebrating the fact that “nothing will ever be the same.”  In the process of embracing change, though, we often lose sight of the paradox that stability becomes ever more valuable as more and more of our surroundings are put into play.  Institutions and individuals that understand where and how to offer stability will create enormous value in the changing times ahead.

I will explore the diminishing value of transactions.  Many of us have become enamored with the ease of doing transactions on the Internet.  One click shopping is deeply seductive.  The transaction mindset has even made headway on social networking sites where the ease of “inviting” friends has drawn many of us into an escalating game of building ever larger social networks of “friends.”  We talk glowingly about relationships on the Web, but too often when we take a closer look, we find that many of these “relationships” are simply transactions under a different guise. Focusing on transactions will guarantee diminishing returns. Deep relationships become increasingly valuable in times of widespread change (and, yes, I know that “weak ties” are also important, but not as a replacement for deep relationships – in fact, deep relationships are essential to capture the full value of weak ties).  Once again, institutions and individuals that understand where and how to build these deep relationships will have a significant advantage.

I will explore the diminishing value of advertising.  Ask the management team of any Internet business about revenue models and, more likely than not, you’ll get the confident answer that advertising will provide the necessary revenue.  Even enterprise software businesses are beginning to consider advertising as a promising revenue source.  There’s no doubt about it, Internet advertising expenditures will continue to rapidly grow over the next several years. But I have more than a passing suspicion that advertising revenue streams are vulnerable in the longer term.  As the long tail of advertisers crowds onto the Internet and as customers become more protective of our attention, I suspect that online advertising will begin to run into seriously diminishing returns. Without developing the detail right now, let me suggest that traditional models of advertising where vendors pay for messages to be delivered to prospective customers will be challenged longer-term by various forms of collaboration marketing and advisory services where customers pay trusted advisors to recommend relevant products and services.  In the short-term, steadily improving algorithms for targeting ads will continue to draw advertisers onto the Internet and provide an attractive revenue source for Internet businesses. Unfortunately, this short-term advertising revenue growth has had a narcotic effect and made a lot of online businesses lazy. Longer-term, I anticipate that most businesses online will have to make money the old fashioned way – by offering products, services and experiences so valuable that people will actually pay money for them. Those who begin to develop this discipline today will profit in the long-term.

I will explore the growing value of place.  I have actually addressed this theme already.  As many of you know, I believe the world will become a lot more "spiky" , while paradoxically becoming flatter in terms of connectivity.  The much vaunted “death of distance” joins the “paperless office” as a too simplistic extrapolation of information technology. The more connected we become, the more intense our need to accelerate talent development will become.  People who come together in dense urban areas will be much more successful in developing their talent than those who remain isolated in remote rural areas, even if they have the best broadband connections.  Most people understand this.  That is why, on a global scale, the trend towards urbanization is accelerating rather than slowing down, even among the most wired digital elites in our younger generations. Place matters more than ever and where we choose to live will increasingly determine how successful we become.

I will explore the growing value of bold leadership.  In an era where the “wisdom of crowds” and empowerment are the watchwords of the digerati and where we generally have become increasingly cynical about the leaders of many of our largest institutions, we may lose sight of the importance of visionary leadership. We can take the notions of emergence and self-organization too far and dismiss the role of forceful leaders. In times of great uncertainty and rapid change, unprecedented opportunities arise to shape our environments to create even more value.  Shaping requires deep insight into the fundamental forces at work and powerful personalities to communicate conviction and persuade many who are on the sidelines that the rewards outweigh the risks. Even our most cited examples of collective intelligence, initiatives like Linux and Wikipedia, would have died stillborn (as most open source initiatives do) if it had not been for the forceful leadership of personalities like Linus Torvalds and Jimmy Wales. To be sure, this new generation of leaders employs a different set of techniques relative to more traditional leaders, but their leadership is essential to the success of these initiatives. Those who are able to exercise this forceful leadership and attract and mobilize others will reap significant rewards in the decades ahead.

I will celebrate length while appreciating brevity.  OK, this may be somewhat self-serving.  Having never mastered the art of the short form, I necessarily harbor a certain attachment to longer essays and, dare I say it, even the endangered book.  In times of rapid change, there is an understandable temptation to sample briefly and quickly from many sources, never lingering too long with any one idea or source.  As we race to keep up, we avoid or quickly discard anything that threatens to take up too much of our valuable time and attention.  But the risk is that we lose any sense of texture or deep structure that would help us to make sense of the changes going on around us and to make connections that might otherwise remain hidden in the whirlwind of events and distractions occupying our day. Vicious cycles begin to play out, where the more we surf from one source to another, the more sense of urgency we develop about falling behind amidst the rapidly proliferating long tail of resources available to us.  Those who invest the time to go below surface events and explore deep structures will be in a far better position to anticipate change and stake out positions that matter rather than simply racing to react to the latest unexpected event and spreading themselves precariously across to many fronts.

Before everyone jumps on me for the contrarian and somewhat retrograde views expressed above, let me hasten to add that I too appreciate the value of change, transactions, advertising, virtual connections, empowerment and brevity. Having recently returned from Vietnam, though, I have gained a renewed appreciation for the traditional Asian concept of yin and yang – two fundamentally opposing forces that come together to complete the world.  I simply want to restore some of the balance that we often lose when we get caught up in the events of the moment.  That’s the essence of my New Year’s resolutions – invest the time required to maintain balance in a time of great flux. I promise to be more frequent in my postings, but probably not a lot shorter.

Institutional Innovation

Executives spend a lot of time these days worrying about innovation.  Innovation is a key engine for growth and profitability yet few companies do it well and consistently.  Even more fundamentally, few companies think broadly enough about innovation.

Mention innovation and most executives immediately focus on product innovation.  Some will expand the scope to include process innovation.  But few venture beyond to explore other levels of innovation.

Seeking More Robust Forms of Innovation

Here’s the rub.  Product and process innovation tend to be event driven – someone comes up with a great new idea, applies it and reaps the rewards. But the rewards offer diminishing returns.  We all know that product life cycles are steadily compressing and markets are fragmenting into a long tail of endless niches.  Early growth from new product introductions rapidly peters out and then revenue begins to slide precipitously towards the inevitable (and increasingly near-term) product retirement.

Process innovation can yield longer-term returns.  Yet, even here, process life cycles are also compressing in the face of rapidly changing business environments.  In a much more connected world, processes can also be more readily copied. The ability to generate more value through process learning soon runs into the diminishing returns reality of the well-known experience curve – greater and greater effort must be invested to yield the same degree of performance improvement.

In a world where profitable growth is the key to value creation, companies need to find ways to sustain and amplify the rewards of innovation. To do this, executives will need to expand the scope of innovation well beyond product and process to a much broader terrain – institutional innovation.

What do I mean by institutional innovation?  It redefines roles and relationships across independent entities to accelerate and amplify learning and reduce risks. The next generation of institutional innovation will seek more productive ways to connect with talent wherever it resides and build relationships that foster and focus learning rather than taking the walls of the enterprise as a given.

Institutional innovation in the twentieth century focused on creating scalable institutions through standardized product design and design of business processes to cost-effectively serve mass markets. In the twenty first century, the focus of institutional innovation will shift to foster scalable learning across institutions.

What’s Different?

This is much broader than the current fad of open innovation.  Open innovation focuses narrowly on accessing third party resources to support product innovation initiatives.  The institutional innovation perspective expands the horizon to include all core operating processes of the enterprise – supply chain management, product innovation and customer relationship management.  Most of the prominent examples of open innovation tend to highlight transactional approaches to accessing existing third party resources, especially knowledge that can be codified.  The institutional innovation perspective focuses on approaches to build scalable, long-term trust based relationships that can accelerate learning on all sides by more effectively accessing tacit knowledge.

This is also quite different from the concept of “management innovation” that Gary Hamel first outlined in his Harvard Business Review article "The What, Why, and How of Management Innnovation" (see my review here) and more fully develops in his recently released book The Future of Management. For Hamel, the primary focus of innovation remains within the walls of existing institutions – he rightly points out that significant value can be created by re-thinking the management processes that drive these institutions but, as the examples he uses in his article and book demonstrate, he is largely concerned with different approaches to managing the resources within institutions rather than across large numbers of institutions.

The companies that excel at institutional innovation will lead the next wave of wealth creation.  We are only at the earliest stages of this kind of institutional innovation, so there is both a lot of opportunity and a lot of uncertainty regarding the approaches with the most promise. JSB and I have offered some early perspectives on this in our writing on The Only Sustainable Edge, Creation Nets and From Push to Pull.

Institutional Design Principles

In thinking about institutional innovation, it is useful to highlight promising design principles that offer the potential to accelerate learning:

Diversity.  As Scott Page and others have persuasively suggested, new insight and learning tends to increase with cognitive diversity. This principle highlights the importance of designing institutional arrangements that extend well beyond a single institution, with particular attention to the opportunity to connect to diverse pools of expertise and experience. Diversity can often be enhanced by connecting into spikes – geographic concentrations of talent – and by targeting “brokers” within social networks, creating a multiplier effect in terms of the number of participants that are potentially accessible.

Relationships.  It is not enough to have cognitive diversity.  By itself, cognitive diversity often breeds misunderstanding and mistrust, seriously limiting the opportunity for people and institutions to learn from each other.  Long-term trust based relationships, on the other hand, make it easier to engage in productive friction – the clash of diverse perspectives in ways that produces deep new insight and learning. The challenge is that these kinds of relationships often take a long time to develop and are hard to scale.  Innovative institutional arrangements can help to accelerate and scale the formation of these kinds of relationships.

Modularity.  When activities are tightly specified and hard-wired together, the opportunities for experimentation and tinkering are very limited.  Segmenting people and activities into discrete modules with well-defined interfaces can help to create much more space and opportunity for distributed innovation and learning.

Federated decision-making.  To encourage distributed innovation and learning, it is helpful to distribute decision-making into self-governing units while at the same clarifying dispute resolution and escalation protocols to ensure that prompt action can be taken across business units when required.  If structured appropriately, these dispute resolution mechanisms can become fertile grounds for productive friction that in itself drives learning.

Reputation mechanisms.  As relationships scale, it becomes harder to develop a clear view of the full range of experience and expertise available to address challenging problems.  Reputation mechanisms can play a vital role in enhancing findability but also help to reinforce incentives to participate and contribute.

Feedback loops.  More broadly, there is enormous value to investing in performance measurement systems and structuring performance feedback loops so that participants can reflect on their practices and focus their efforts to improve performance.  This task becomes much more challenging when activities and participants are scattered across a large number of institutions and geographies, but the rewards in terms of learning are far greater given the opportunity to compare and contrast performance across a larger number of participants.

Incentive structures.  Focusing narrowly on near-term cash incentives undermines the ability to build trust and foster learning. By expanding incentives to include talent development and capability building, institutional innovators have the potential to turn zero sum games into positive sum games, where the prospects of expanding rewards encourage participants to adopt longer time horizons and invest more in collaborative undertakings.

Deployment Approaches

There’s a massive opportunity for institutional innovation building upon these design principles.  One of the key pitfalls, though, is the temptation to map out detailed blueprints of new institutional arrangements before deploying any changes.  In the highly specified, hardwired institutions of the twentieth century, this level of advance analysis and planning was critical.  These new design principles, however, make it possible to pursue a much more incremental approach to institutional innovation. New institutional arrangements consistent with the design principles above can be deployed in stages to facilitate learning and refinement.

Bottom Line

As executives start to focus on the opportunity for institutional innovation, they could begin by asking the following questions:

• What are the top one hundred companies with world-class capabilities that are complementary to our own?
• What, if any, relationships have we built with these one hundred companies?
• How could we re-design these relationships along the lines of the principles presented earlier to enhance the potential for learning on both sides?
• What relationship networks are these one hundred companies participating in and how could we begin to participate in relevant networks to further expand our opportunities for learning?

In thinking about innovation, executives would be well served not to focus exclusively on finding talented product design maestros or even process design experts, but rather creative institutional designers who can challenge and re-think their existing institutional arrangements from the ground up.

These institutional designers will unlock a steady flow of product and process innovations.  Without their help, executives will continue to struggle with isolated innovation initiatives that show great promise at the outset, but rarely deliver on their full potential.  Even when the full potential of these initiatives is realized, this potential is inherently limited.  Far better to re-think the innovation opportunity at a much more fundamental level – a level that keeps on giving.

For those who doubt the power of institutional innovation, reflect on what has been the single most wealth creating innovation over the past several centuries.  The steam engine? The telephone? Ford’s assembly line approach to manufacturing? Fuhgeddaboutit.  It was the development of the limited liability joint stock company – a profound institutional innovation.

Convergence or Divergence?

Convergence is re-shaping the technology, telecommunications and media industries. Paradoxically, though, divergence may actually be a more powerful theme in determining who creates value and who destroys value.

Read the business press and convergence is everywhere.  Devices are becoming more versatile, embedding functionality that cuts across computing, communications and consumer electronics.  Internet companies are bidding for wireless spectrum.  Network service providers are introducing devices.  Device makers are backward integrating into Internet services. 

Boundaries are not just blurring; they seem to be disappearing. As everyone seeks to get into everyone else’s business, it is easy to fall prey to a belief that all distinctions will fall by the wayside and we will confront an undifferentiated mass of competition. My own personal view is that this is a transitional phenomenon. New boundaries are forming and some of the emerging patterns are already discernable.

Where Convergence Matters

Stepping back from events over the past fifteen years, convergence has been most significant at the network platform layer – here we have seen a growing convergence of voice, data and video networks shaped by a shared set of technology standards.

The convergence of network platforms directly contributes to two other forms of convergence – convergence of market power at the customer level and greater collaboration among enterprises to deliver value to customers.

Converged networks systematically eliminate shelf space constraints, making it easier for customers to access a broader range of products and providers on a global scale. (As an aside, these converged networks paradoxically generate much greater diversity and fragmentation of markets into the myriad niches that populate the Long Tail). These converged networks also provide customers with much greater information about product/service offerings and vendors, including the ability of customers to connect with each other and compare their experiences with products and vendors.

As relative scarcity shifts from shelf space to attention, customers gain greater power and vendors experience increasing margin squeeze. The natural reaction is to cut costs but many companies lose sight of the fact that cutting costs alone is a losing game.  In increasingly competitive markets, cost savings are rapidly competed away and captured by customers.  The result is a steadily shrinking business.  The only way to continue to create value in this kind of environment is to find major new growth platforms.

Fortunately, converged network platforms also create an opportunity – they enhance the ability to collaborate across institutional and geographic boundaries. By providing an opportunity to access and mobilize complementary resources, they offer powerful platforms for leveraged growth (purchase required) – delivering greater value to customers by bringing together third party resources.

Where Divergence Matters

So, power is converging at the customer levels and providers have an opportunity to collaborate more effectively to deliver even more value to customers – these two forces of convergence are accelerating and intensifying a broad trend towards divergence in business models.

For those following my writings, you know what is coming next – my personal belief that most companies today are an unnatural bundle (purchase required) of three very different kinds of businesses.

• Infrastructure management businesses (IMB)  – high volume, routine processing businesses – think of contract manufacturers, logistics providers and call center operators as relatively pure play examples of these businesses
• Customer relationship businesses (CRB) – businesses that get to know individual customers extremely well and, based on that understanding, help to access relevant resources for these customers – relatively pure play examples of these businesses include large advisory firms that help large enterprise customers decide what form of IT outsourcing to pursue and help these large enterprises to evaluate and negotiate with the right mix of outsourcing service providers.
• Product innovation and commercialization businesses (PIC) – businesses that focus on developing innovative new products and services, getting them into market quickly and accelerating adoption of the products – think of semiconductor firms operating without their own fab facilities as relatively pure play examples of these businesses.

The Performance Penalty

While there are some pure play examples of these businesses as indicated above, they are exceptions. Most companies tightly bundle these three businesses together despite very different economics, skill sets and even cultures – leading to significant underperformance across all three:

• IMB – economies of scale, standardized operations skill sets and cost conscious cultures
• CRB – economies of scope, direct marketing skill sets and customer service oriented cultures
• PIC – economies of speed, product innovation skill sets and creative cultures

While economics differ radically across all three business types, each business type has the potential to be very profitable, provided management understands what is required for success and manages the business in a focused manner. Two of the business types – infrastructure management and customer relationship – are driven by economics that favor large scale or scope based operations, so there will be accelerating concentration and consolidation in these two business types. In these arenas, unbundling will be prelude to a much more focused process of rebundling, driving significant growth.  The third business type – production innovation and commercialization – is more likely to fragment over time given the importance of attracting and retaining the most creative talent and the importance of agility in the economics of speed.

Sound historical reasons explain why these businesses came to be bundled in the first place. But today’s converged network platforms now create the opportunity to unbundle them.

The process is well underway, although proceeding at different paces in each industry and geography. For example, the broad trend towards outsourcing and offshoring over the past decades can be understood as a systematic stripping out of IMBs from larger companies.

The next wave of opportunity comes from a systematic splitting of PICs and CRBs – a process already underway in certain industries, for example the rise of Original Design Manufacturers (ODMs) in high tech or the unbundling of research in the pharma industry.

Broader forces will accelerate this divergence of business models. As markets fragment, product companies will be under increasing pressure to broaden product reach as far as possible and not be constrained by their own distribution capabilities. As attention becomes scarcer, customer relationship businesses will need to be more helpful to customers by providing them with a broader array of options and not be constrained by their own product offers.

Implications for Specific Industries

That’s the broader trend towards divergence that paradoxically emerges from convergence. While I can’t develop here the full implications of this perspective for companies in industries like media, technology and telecommunications, let me be provocative and assert my personal view that companies in these three industries will face the following sets of choices:

Media industry – Most media companies today in their core genetics are product innovation businesses, even though they have the other two business types within their companies as well. Here’s the strategic challenge: long tail dynamics make product innovation businesses increasingly challenging in terms of building and sustaining scale. As niches proliferate and a growing array of media options competes for audience attention, it will be harder and harder to find the blockbusters that drove scale in most traditional media companies. For those who want to build large and scalable companies in the media industry, the key opportunity will be to focus on customer relationship businesses.  There’s a growing unmet need for pure play versions of this business type as content proliferates and customers seek to improve their return on attention. Infrastructure management businesses like running large scale printing operations and server farms will be increasingly farmed out to pure play providers that are likely to come from outside the traditional media industry.

Tech industry – Most tech companies today in their core genetics are product innovation businesses – run by engineers who get status and success by coming out with the latest and greatest product. Long tail dynamics again make building and sustaining scale in the tech industry as a product innovation business very challenging. On the other hand, as more and more tech products evolve into remotely delivered shared services, there are significant opportunities to build focused IMBs. Also, as customers continue to wrestle with the complexities of rapidly evolving shared services, there are increasing opportunities to build focused CRBs with a deep understanding of customer needs and the ability to evaluate and mobilize appropriate services for individual customers.

Telecommunications industry – Most telecom companies today in their core genetics are IMB’s running large scale, routine processing operations. These companies have two primary options:

• Learn to love commodity pipe businesses and recognize that there is an opportunity for substantial profitability as consolidation and concentration plays out in the classic IMB business.
• Leapfrog to becoming a CRB by developing a deep understanding of end users and becoming more helpful to them in sourcing appropriate telecom (and other) services. Extreme examples include a major wireless provider in India that outsourced its entire network infrastructure and the Mobile Virtual Network Operators (MVNOs) that have emerged in the wireless market in the US and other developed economies.

The Customer Focus Test

As I suggested in a previous blog, from my experience very few companies are truly customer focused in the sense of a CRB.  To test the degree of customer focus, I offer three questions:

• Who in the organization holds real decision-making power? Is it the organization that manages relationships with the customer or is it some other group?
• What are the primary measures of performance for the firm? Are the primary measures customer centric or product centric?
• What is the primary focus of the brand promise of the company? Is it a customer-centric promise or a product/vendor-centric promise?

When confronted with these three customer focus questions, most executives begin to realize the enormous distance they would need to travel to become a true customer relationship business. The companies that really succeed in the customer relationship business will have no trouble meeting this test.  All the rest had better decide which of the other two businesses they really want to focus on.

Are We Compromising on Performance?

In wrestling with the divergence of business models that inevitably follows the convergence of network platforms, executives would do well to focus on three questions:

• Where do we have distinctive and world-class capabilities today and where do we generate the most significant economic returns?
• Are we compromising those capabilities and returns by participating in the other two business types?
• Are we doing everything we can to access and leverage world-class capabilities in the other two business types?

Implications for Industry Boundaries

Will industry boundaries across technology, telecommunications and media still matter in this brave new world?  Well, it depends on what business type we are talking about.  Here’s my guess: industry boundaries will disappear first in the IMB arena, they will more gradually erode in the CRB arena and they will morph in interesting and unpredictable ways in the PIC arena as we move from a product to a service world.

The Bottom Line

As we wrestle with the challenges and opportunities of convergence and divergence, let’s not get too focused on the technology or product level, or even the industry level, and instead let’s invest the time required to sort through the implications for business types and business models.  At the end of the day, this is where the most value will be created and the most value destroyed. And here we may find that divergence matters more than convergence.

Tests for Customer Focused Companies

Most companies claim to be customer-focused, yet few are. In a world where customers (both end consumers and intermediate customers) are becoming increasingly powerful, all companies declare that they are “customer-focused”. At one level this is a truism – all companies must have some degree of customer focus just to survive in increasingly competitive markets.

But, let’s move beyond this generic level and apply some real tests of customer focus. We’ll find that the practice rarely matches the rhetoric. I apply three questions to determine whether companies are truly customer focused. These three questions zero in on the most fundamental elements of a firm – decision-making power, performance metrics and brand promise. It is surprising how few companies meet these tests.

Power

Who in the organization holds real decision-making power? Is it the organization that manages relationships with the customer or is it some other group?

In every firm, even in complex matrix ones, one set of executives typically holds the real decision-making power. More often than not, they are the executives managing major product groups rather than executives assigned with the responsibility of managing customer relationships.

Now, of course, executives with product accountability have to be focused to some degree on serving the needs of customers, otherwise their products would not sell.  But, at the end of the day, their primary loyalty is to the product, not to the customer. If products sales are flagging, they will aggressively seek to market and sell their products, even if they are not the most appropriate products for specific customers. In this case, who champions the customers needs?

In fact, many firms do not even have a senior executive accountable for building relationships with customers.  At best, these firms may have a marketing executive, sales executive and perhaps even a customer support executive, but these are functional silos leaving no single executive responsible for building and managing end to end relationships with customers. How can a company claim to be customer focused if they do not have an executive accountable for building relationships with customers? Even where such an executive exists, this executive rarely wields the greatest decision-making power within the firm.

Performance

What are the primary measures of performance for the firm?

Ask most executives about the performance of their firm and they will discuss in great detail their profitability by product or, perhaps if they are a retailer or asset intensive manufacturing company, their profitability by facility.  Ask them about their profitability by customer and you will more likely get a blank stare. 

Few companies systematically track profitability by customer.  They are usually not able to answer which 20% of their customers account for 80% of their profitability.  Even fewer could tell you about the life time value of their customers. And even fewer could tell you what share of an individual customer’s “wallet” they represent.

If a company is truly customer focused, it would seem natural that they would be closely tracking their customer economics.  If we accept that people generally focus on what gets measured, we would have to say that people in most companies are unlikely to put their highest priority on customer performance.

This lack of focus on customer profitability is not accidental.  Two factors explain the persistence and prominence of other metrics. Throughout most of the previous century, production economics or facility economics (e.g., retail stores or branch outlets) dominated the financial performance of most firms.  While the economics of the firm are shifting to the growing challenge of finding and retaining customers, our financial accounting systems continue to focus on what drove performance in the past.  A second factor involves the difficulty of tracking and measuring customer profitability for many companies.  Advances in information technology are making this task easier, but again our accounting systems are slow to catch up.

Now, I know that most companies closely track their overall market share and some even track it by customer segment. But, at best, this would mean they are market focused.  They have very little investment in tracking their customer performance.

And, yes, I know that many companies track customer satisfaction metrics.  These may play a role in the performance evaluation of individual contributors and perhaps even become a factor in some compensation decisions.  But in most companies these customer satisfaction metrics play a very modest role relative to product or facility profitability metrics.

Customer satisfaction metrics are certainly a key driver of customer profitability, but they are not the only driver.  In the absence of a broader focus on customer profitability, many of the actions required to serve customers effectively are likely to get little, if any, attention.

At the end of the day, money matters more than any other dimension in performance evaluations and compensation decisions.  Most companies keep track of their financial performance along dimensions other than customer profitability.  How can they claim to be customer focused if they do not systematically track financial performance along this dimension?

Promise

What is the primary focus of the brand promise of the company?

Most companies have a vendor-centric or product-centric brand promise – buy from me because I have great products or because I have a great company.  Very few companies have developed a customer-centric brand 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 best products, services and experiences that meet your individual needs.

Bottom line

Choices need to be made.

Few companies are customer-centric in terms of these three basic dimensions of the firm. And perhaps they don’t need to be.  I have suggested in earlier writing that most companies today are an unnatural bundle of three very different kinds of businesses – infrastructure management, product innovation and commercialization and customer relationship management. 

Most companies are ultimately going to have to choose which of these three businesses they really want to be in, shed the other two businesses and aggressively grow the business they have chosen, aided by the enhanced agility and focus that they have achieved. If they do not make these difficult choices, they are likely to under-perform as they make the inevitable compromises required to accommodate the competing demands of three very different kinds of businesses.

When I pose this choice, most executives gravitate towards the third business type – the customer relationship business. In part, they do this because they genuinely believe they have a customer centric company. 

When confronted with the three customer focus questions, though, they begin to realize the enormous distance they would need to travel to become a true customer relationship business.  The companies that really succeed in the customer relationship business will have no trouble meeting this test.  All the rest had better decide which of the other two businesses they really want to focus on.

Unanswered Questions at Supernova 2007

I have been unusually quiet here recently because I have been going through a major transition.  About six weeks ago, I joined Deloitte & Touche USA LLP with a mandate to establish a major new research center in Silicon Valley.  The Center will explore key business issues created by the intersection of business strategy and information technology.

I will be serving as Co-Chairman of the new research center along with John Seely Brown and we have already enlisted the support of Lang Davison as Chief Content Officer.  Until co-founding the center with us, Lang had been the Editor of The McKinsey Quarterly. Lang and I go way back in terms of our collaboration – in fact, he was a key collaborator in the development and writing of both Net Gain and Net Worth and has edited all our subsequent Quarterly articles.

Last week, Kevin Werbach asked me to address his Supernova conference and offer a preview of some of the questions that will form the foundation of the research agenda for the new center.  We are still at a very early stage in defining the research agenda, but it was a great opportunity to get some feedback and input from very smart folks. It occurred to me that I could throw the net even broader through my blog and seek out further input to help shape our research agenda. So, here’s an abbreviated version of the presentation I gave at Supernova – please let me know your thoughts and ideas on how to increase this research agenda’s relevance and power.

Questions are often as valuable as answers

It’s appropriate to step back occasionally and reflect on what we don’t know, rather than simply sharing what we know. In times of rapid change, asking the right questions is often as important as the answers – at least they help us figure out where we might start looking for answers. There is no shortage of questions – the key is to focus on questions that are not just intellectually interesting, but also where significant economic impact is at stake. These are the questions that will focus our research agenda.

Foundation questions – what is going on in the world around us?

1.  What if there is no equilibrium?

We all understand that the component technologies of our new infrastructure – computing, storage and networking – continue to advance at exponential pace.  In fact, this is the one central difference between this new generation of infrastructure and all the previous generations of infrastructure – for example, railroads, electricity and telephones – that shaped our economies in the past. All of these earlier generations were characterized by a major technology breakthrough, followed by the adoption of key standards and a diminishing rate of performance improvement. Our new infrastructure defies this pattern and proceeds with exponential rates of performance improvements.

Here’s the paradox: at the same time, we cling to traditional equilibrium concepts and institutions  that emerged and prevailed in more stable times. Nathan Mhyrvold highlighted in his talk yesterday the contrast between the exponential advance of technology performance and the linear thinking of most executives. Clayton Christensen got the attention of the business world with his perspective on disruptive innovation – but even that is a punctuated equilibrium view – it holds on to the assumption that equilibrium will eventually return.

A more specific question might be: what are the institutional architectures required to operate in a world where there is no equilibrium? Early conventional wisdom suggest that these architectures should focus on agility and flexibility, but that misses the real opportunity – balancing agility with the persistence and stability required to build and deepen long-term trust based relationships. Being able to discern what needs to change and what needs to remain stable may be the greatest challenge of all.  In looking for early indications of what these architectures might look like, the richest sources of institutional innovation will be China and India, not the U.S. or Western Europe

2. Can the firm survive as the action flows to the edges?

The early view of the Internet was that it would be a catalyst for the fragmentation and marginalization of firms. Tom Malone at MIT wrote an interesting book forecasting the rise of the E-Lance economy.

An alternative view suggests that firms will unbundle and rebundle in ways that lead to even greater concentration and consolidation (although paradoxically at the same time facilitating more decentralization and power at the edges). In the process, the rationale for the firm will fundamentally shift – from Ronald Coase’s classic view of the firm as an institution designed to economize on transaction and coordination costs we are likely to shift to a rationale focused on accelerating talent development.

3. Are all ecosystems created equal?

The term “ecosystem” is used so broadly and loosely along with lots of related words – networks, webs and communities– that it runs the risk of losing all meaning and blending into the banal. At one level, we are all interdependent and operate in a broader fabric of cooperation – from the earliest hunter gatherers to today.

We desperately need a workable taxonomy, not just for its own sake but to help us see what is new and help us to choose what forms of cooperation have the greatest power to create more business value in specific contexts.

Looking ahead, I would suggest that networks of creation and economic webs will trump all other ecosystems in value creation and capture opportunities because these have the ability to embrace and extend the value creation potential of other ecosystems

4. If the world is so flat, why are spikes becoming more prominent?

Once again, the early view was that geography doesn’t matter in the age of electronic networks – we were finally going to see “the death of distance.” Tom Friedman captured our imagination with his view of The World Is Flat.  But we need to pay attention to the perspectives of Richard Florida, the author of Cities and the Creative Class and The Flight of the Creative Class as well as a provocative Atlantic Monthly article, who keeps focusing on an inconvenient truth: the trend towards coming together in dense urban areas to create spikes of talent is accelerating, rather than disappearing, on a global scale. How to resolve the paradox of greater spike formation in a flat world?

In fact, geography may matter more than ever. The flat world may be making spikes even more necessary, attractive and scalable. Spikes appear to be playing an increasingly important role in talent development. If talent development is becoming more critical to the success of firms, what is the explicit spike strategy of each of our firms?

Strategic questions – what are the most promising actions to create and capture value?

1. Is adaptation all there is?

Conventional wisdom holds that, in the absence of equilibrium, adaptation is the best strategy – we need to develop the capability to sense and respond to the changes going on around us.

While adaptation is certainly necessary it misses the real opportunity. With accelerating change and growing uncertainty, there are increasing opportunities to shape outcomes in ways that were simply not feasible in more stable times. In particular, these shaping strategies focus on generating positive incentives that can mobilize and align large numbers of other participants.

2. Can we escape the Red Queen effect?

There’s a powerful image that resonates in corporate boardrooms around the world – the image of the Red Queen running faster and faster just to stay in the same place. Adaptation in a world of more rapid change implies running faster just to stay in same place

Product and process innovation only provides temporary relief for the Red Queen effect as companies become more adept at copying the advances of others. We need to harness institutional innovation and move from scalable efficiency to scalable learning so that we can begin to learn faster and find ways to get ahead of the pack in a more sustainable fashion

3. As “L curves” replace “Bell curves”, what are the most promising routes to the head?

As I have written recently, we are shifting from a Gaussian world of bell curves where averages have meaning to a Paretian world where extreme events prevail. Chris Anderson in his book The Long Tail showed great insight in focusing on the long tail of Pareto “L curves” and how to play there, but in the process he may have distracted us from the real opportunity. Perhaps the most interesting question is how to use the long tail as a launch pad for head strategies. In this context, developing privileged access to concentrations of knowledge flows on the edge holds great promise.

4. We have a growing realization that stocks of knowledge are diminishing in value relative to flows of knowledge, but what is required for effective participation in the highest value flows of knowledge? How do we avoid drowning in proliferating flows of knowledge while ensuring that we tap into the most relevant flows?

Stocks of knowledge diminish in value much more rapidly in times of rapid change. As a result, strategic advantage increasingly depends on privileged access to knowledge flows.

A point of view about destination helps to generate and filter knowledge flows, but productive friction helps to sustain flows.  Here’s a paradox – the more uncertain the environment becomes, the more important it is to have a destination clearly defined in order to make sense and make progress. One of the biggest risks is that companies spread themselves too thin in rapidly changing environments and fail to really nurture the knowledge flows that matter the most.

5. What are the opportunities for the bottom of the pyramid to attack the top?

C. K. Prahalad has helped us to understand the fortunes that are waiting to be made by creatively serving customer needs at the bottom of the pyramid. Once again, though, this perspective may distract us from another opportunity – the bottom of the pyramid may become a launch pad for successful attacker strategies challenging incumbents in more developed economies – the institutional innovation required to serve customers at the bottom of the pyramid can also be used to carve out significant share in more developed economies – something that JSB and I have described as “innovation blowback”.

6. How do we measure success when so many of the rules are changing?

Financial metrics matter more than ever, but the problem is they are lagging indicators – what we need are leading indicators. We need a new set of leading indicators tied to two sources of power within networked economies – talent and customers. As I have written before, some interesting new measures are return on attention (ROA), return on information (ROI) and return on skills (ROS) – measure both from the perspective of the firm and of the customer/employee.

Platform questions – how can various types of platforms augment our capabilities?

1. When is self-organizing not enough?

In focusing on various forms of decentralized collaboration, we have tended to celebrate the self-organizing characteristics of these systems. Perhaps we need to shift back and recognize that successful collaborative creation initiatives are never completely self-organizing. Every one of these efforts depended on an orchestrator who carefully and thoughtfully defined a minimal set of rules required to kick-start collaboration – we need to better understand what these rule sets are and to be thoughtful about the different rule sets required for different types of creation efforts.

A lot of work has been done on governance mechanisms in open source software, but there’s a lot of uncertainty about how broadly these governance mechanisms might be applied beyond open software.  What modifications might be required to governance mechanisms or what modifications to the creation process might be necessary to extend these mechanisms to other domains beyond software?

2. How are pull platforms likely to evolve?

As the pace of change accelerates, we are in the midst of a broad transition in terms of how we access and mobilize resources. As JSB and I have written elsewhere, we are moving away from push programs that attempt to forecast demand and make sure that the necessary resources are available when and where needed. In their place, we are seeing the emergence of much more flexible pull platforms that help people connect with the resources that are most relevant to them whenever and wherever they need the resources.

Push programs treat people as passive consumers (even when they are producers like workers on an assembly line) whose needs can be anticipated and shaped by centralized decision-makers. Pull platforms treat people as networked creators (even when they are customers purchasing goods and services) who are uniquely positioned to transform uncertainty from a problem into an opportunity.

The pull platforms that we now have are only the earliest stages of development. To harness the full potential of these pull platforms we will need to move to much more robust federation governance structures that accommodate services from a growing number of independent and diverse participants.  The lean manufacturing approaches of leading edge manufacturers succeed only because they dramatically narrow the number of participants. Different governance structures are likely to be required to scale pull platforms.

3. What is the next generation of IT architecture?

Until now, the trajectory of IT architectures has been from the inside out. Starting in the centralized glass house of large enterprises, these architectures slowly evolved to embrace departments and then the desktop, until finally, in tentative fashion, they reached out to connect selected business partners. These architectures are not likely to be scalable in terms of the ability to connect and coordinate activities across large numbers of independent business partners. As SOAs are held captive by IT architects within the enterprise, attention will shift to outside-in, relational architectures that first take shape across enterprises.

What is different about these architectures? They are designed from the outset to support sustained collaboration across large numbers of enterprises, robustly addressing a number of key challenges, including the reality of many autonomous entities, rather than one control point and the need to effectively connect the extraordinarily heterogeneous technology platforms and skill sets likely to prevail across these autonomous entities. Rather than assuming fine grained, short-lived transactions are the rule where one can be optimistic about completion, these architectures must cope with coarse grained, long-lived interactions where one needs to be more pessimistic and develop appropriate compensation mechanisms in case of failure. More broadly, I expect to see a move from transactional architectures to relational architectures, shifting from supporting discrete transactions like a request for inventory availability or the booking of a sale to architectures designed to support enduring and deepening relationships of individuals and institutions.

Without these outside-in architectures, companies will be constrained in accelerating talent development because existing technology architectures limit the ability of individuals to connect into rich networks of specialization and push themselves to get better faster by working with others. Individuals and institutions will still find ways to connect into these networks, but the scope and scale of the interactions will be much more limited

There you have it, three broad sets of questions – dealing with foundations, strategies and augmentation platforms. They get to very basic issues regarding value creation and value capture –and they’re more than enough to keep a research center fully occupied for some time

This is a first cut at the questions that John Seely Brown and I, along with our senior colleagues, will be pursuing through the new Deloitte research center. We’ll have a critical mass of research staff within the research center itself but we want to pursue this research with an open architecture approach. We’ll be reaching out to, and collaborating with, people across many institutions with relevant experience and interests. We look forward to collaborating on some of the most challenging issues confronting executives today.

Once again, I encourage anyone with thoughts or ideas on this research agenda to connect with us and help us to refine this “alpha” version of our research agenda.

The Power of Power Laws

We’re shifting from a Gaussian world to a Paretian world, with profound implications for business.  Johann Gauss was a famous mathematician in the 18th century and Vilfredo Pareto was a great economist who lived across the cusp of the 19th and 20th centuries. So, what possible relevance do these dead white men have for business today?

Gauss versus Pareto
Gauss contributed the Gaussian distribution, also known as the normal distribution, as a way to characterize the probability of events – most of us know it as the familiar bell curve with a significant hump in the middle and two relatively modest tails on either side of the hump.  Pareto, on the other hand, inspired the Pareto, or power law, probability distribution. Chris Anderson’s The Long Tail offers a great contemporary example of the Pareto probability distribution – a few extreme events or “blockbusters” on the left hand side of the curve and a very long tail of much less popular events on the right hand side of the curve. The Pareto distribution has also been popularized as the “80/20” rule.

(Image courtesy of Albert-Laszlo Barabasi, "Linked: The New Science of Networks")

These are two very different ways of viewing the world, with some events following a Gaussian distribution (classic example: the heights of individual human beings) and other events following a Pareto distribution (classic examples: frequency of word use, size of human settlements, distribution of Internet traffic and intensity of earthquakes).

Bill McKelvey, a professor at UCLA’s business school, has written a series of excellent papers exploring the significance and implications of these two world views for business (warning to the casual business reader – these are dense works that cannot be skimmed and certainly should not be perused on a Blackberry lest you experience Berrybite blowback).

In a recent journal article (purchase required) written with Pierpaolo Andriani, McKelvey highlights a crucial distinction between the Gaussian and Paretian worlds:

Gaussian and Paretian distributions differ radically.  The main feature of the Gaussian distribution . . . can be entirely characterized by its mean and variance . . . A Paretian distribution does not show a well-behaved mean or variance.  A power law, therefore, has no average that can be assumed to represent the typical features of the distribution and no finite standard deviations upon which to base confidence intervals . . .

Andriani and McKelvey focus on the desperate efforts of social “scientists” to fit social phenomena into Gaussian distributions.  There is a sad humor in their discussion of the creative approaches used by econometricians to add “robustness” improvements to standard linear multiple regression models, in a vain effort to account for extreme events. As they observe in another paper, “robustness tests bury the most important variance.”

But it is not just social scientists who fall prey to this temptation to adopt a Gaussian view of the world.  Business executives also are drawn to a Gaussian world. At one level it is much simpler – there is a meaningful “average consumer” that can be used to scale products and operations around – and it is a much more predictable world. In many respects, the history of Western business in the twentieth century represents an effort to build scalable operations through standardization designed to serve “average consumers”.

As McKelvey observes in another paper ("Extreme Events, Power Laws, and Adaptation" – unfortunately not yet available online) co-authored with Max Boisot:

Organizations can be shaped or forced into a Gaussian form.  The large hierarchies that managers work in, and the procedures that they impose on their organizational members – the division of labor, single-point accountability, cost accounting, etc. – aim to achieve control by isolating and objectifying.  These managers inherit from the industrial economy a belief that, even where the world is not yet Gaussian, it can be made so through design.

The growth of the Paretian world
Here’s the problem (or opportunity).  Gaussian distributions tend to prevail when events are completely independent of each other.  As soon as you introduce the assumption of interdependence across events, Paretian distributions tend to surface because positive feedback loops tend to amplify small initial events. For example, the fact that a website has a lot of links increases the likelihood that others will also link to this website.

McKelvey and Andriani suggest that Gaussian distributions can morph into Paretian distributions under two conditions – when tension increases and when the cost of connections decreases. In our globalizing economy, tension rises as competitive intensity increases and as business landscapes evolve faster than the capacity of most organizations to adapt.  At the same time, costs of connections are rapidly decreasing as public policy shifts towards freer movement of goods, money and ideas and rapid improvements in the price-performance of IT infrastructures dramatically reduce the cost of information transmission. Bottom line: Paretian distributions become even more prevalent.

(Just as an aside, I wonder what bio-engineering will do to even the most traditional Gaussian distribution – the height of individuals.  As we acquire the ability to genetically engineer the height of our children, will we see height “fads” emerge in the same way we see naming fads evolve from generation to generation today? Perhaps in some generations, tall will be “in” while in other generations short will come back – leading to the crumbling of yet another Gaussian bastion.)

Extreme events
So, why does this matter?  In a world of power law or Pareto distributions, extreme events become much more prominent.  Extreme events can take many forms.  They can be sudden and severe disturbances like a class 9 earthquake or a financial meltdown like the one that occurred in US stock markets in 1987.  As McKelvey and Andriani observe, “the lesson that we can draw . . . is that extreme events, which in a Gaussian world could be safely ignored, are not only more common than expected but also of vastly larger magnitude and far more consequential.”

Our institutions (not just businesses, but also educational and governmental) are largely designed for a Gaussian world where averages and forecasts are meaningful.  As a result, we have evolved a sophisticated set of push programs that have delivered significant efficiency.  In a world of sudden, severe and difficult to anticipate shifts, push programs become much less viable and we need to become a lot more creative in terms of designing pull platforms – something that JSB and I have written extensively about in the past. Bottom line: our institutional architectures, not to mention our technology architectures, will need to be redesigned to cope with a Paretian world.

Using examples like earthquakes and financial meltdowns obscures a related form of extreme event that has a more positive outcome (at least for direct participants) and generally takes longer to play out than the hours or days characteristic of sudden events. As McKelvey and Andriani point out, companies like Google and Microsoft have achieved enormous concentration of economic value creation that defies the averages of the Gaussian world. These extreme events have an interesting property – they emerge first in the “fat tail”, on the edge of conventional business activity, driven by a different view of business opportunity, and then gather momentum until they eventually break into the head of the distribution and change the game for everyone else.  The challenge for business managers is to sort out the signal from the noise in the fat tail and spot early on the emergent extreme events that could reshape the business landscape. The Gaussian focus on averages obscures these events, treating them as meaningless
“outliers” until it is too late.

There’s another form of extreme event that also becomes more prominent in a Paretian world – this is the tendency for extreme forms of clustering in social networks, whether it takes the form of clustering in mega-cities in physical space or clustering of links and traffic on web sites in virtual space. Economic value inexorably follows these social clusters. This also has powerful implications for business, ranging from where to locate operations in physical space to how to redesign institutional architectures to accommodate thousands of business partners. There’s also a public policy implication – in many domains we are likely to see degrees of concentration and consolidation of economic power that is unprecedented (although Pareto just over 100 years ago observed that 20% of the population in Italy owned 80% of the land).

Now, of course, all three of these extreme events are related – the clustering events generate and amplify the positive feedback loops that lead to both sudden and severe negative events as well as the more gradual, but no less significant, positive events.

Searching for simplicity
Besides extreme events, there’s another implication of the shift to a Paretian world.  While on the surface Paretian worlds appear much more complex and unpredictable than the seductive simplicity of the Gaussian world, deep structural forces are at work shaping Paretian worlds.  These structural forces play out at multiple levels of the Paretian world – for example, the local work group, the enterprise, broader process networks, cities, regions or the world.

The problem is that most of our analytical tools are designed to understand Gaussian worlds. These same tools seriously miss, or even distort, the dynamics of Paretian worlds.  We need an entirely new analytical tool kit for the Paretian world.  McKelvy and Andriani, in the journal article mentioned earlier, urge business researchers to learn from

. . . earthquake science where the study of extremes is routine, and complexity science, where focus is on emergent self-organization stemming from agent interdependence and positive feedback, consequent extremes and underlying scale-free theory. . . We see very little in existing social science disciplines that offer anything constructive here.  Only by facing up to this redirection of strategic organization research can it actually become a practitioner-relevant science like the natural sciences.

In the paper co-authored with Max Boisot, McKelvey points to an alternative view of simplicity:

Underlying most power laws is a causal dynamic explained via a scale-free theory. Such a theory points to a single generative cause to explain the dynamics at each of however many levels are being studied.  Scale-free theories yield what [Murray] Gell-Mann . . . refers to as “deep simplicity”. . . . Scale-free theories point to the same causes operating at multiple levels – simplicity here consists of one theory explaining dynamics at multiple levels.

Later in the paper, McKelvey and Boisot offer a suggestion about different strategies for achieving understanding between the Gaussian and Paretian worlds:

Processing dots is appropriate to what we label the routinizing strategy.  Processing patterns, on the other hand, better serves what we call the Pareto-adaptive strategy. Processing dots means processing data, a low-level cognitive activity.  By contrast, processing patterns – pattern recognition – is a high-level cognitive activity, one that involves selecting relevant patterns from among myriad possibilities. . .

In a Paretian world, surface events can become a distraction, diverting attention from the deep structures molding these surface events.  Surfaces are extraordinarily complex and rapidly evolving while the deep structures display more simplicity and stability. These deep structures are profoundly historical in nature – they evolve through positive feedback loops and path dependence.  Snapshots become misleading and understanding requires a dynamic view of the landscape.

The payoff
This is not simply an academic exercise. The rewards for achieving a better understanding of the Paretian world are enormous. Small moves, smartly made, can lead to exponential improvements in wealth creation provided they leverage the deep structures that define Paretian distributions. In contrast to the scaling strategies described earlier in the Gaussian world, different and even more powerful scaling strategies become feasible in the Paretian world, converting instability from a liability into an advantage.

Shifting mindsets
But, as with most things in business (and in life), mindsets become a key stumbling block. McKelvey and Boisot describe the “Gaussian perspective of the world” as one built on atomism, privileging “stability over instability, structure over process, objects over fields, and being over becoming.” Not a bad summary of the way most Western executives view the business landscape. There is a natural and very human tendency to seek out the typical or the average and to search for more predictability.  By implication, a Paretian world requires a much more dynamic view of the world, one that looks for patterns in evolving relationships, rooted deeply in context, and that understands how these changing patterns reshape who we are as well as our opportunities for growth. McKelvey’s provocative work will help to challenge and shift our mindsets.

FAST Strategy and Learning

We live in a world where stocks of knowledge rapidly diminish in value.  Strategic advantage increasingly depends upon privileged access to fresh “flows” of knowledge. But here’s the catch – there are so many flows that there is a real risk of drowning in all the knowledge that is potentially available.  How do executives, already pressed for time, process these flows in ways that accelerate learning and capability building?

Over the past seven years, I have been refining a new approach to strategy that has achieved significant impact with my clients. It turns much of the conventional wisdom about business strategy on its head.  I have written about this approach – something I call FAST strategy – in the past, but I continue to develop the techniques and explore their implications for companies of all sizes.

In my earlier writings, I emphasized the role that FAST strategy can play in building alignment and helping to overcome organizational inertia on multiple dimensions – time horizons, across functions within an enterprise and across networks of business partners. There’s significant value here but, as I gain more experience with the use of this methodology, I have become convinced that there is an even greater value – the ability to accelerate learning and capability building.

We have built institutions that are great at efficiency, but we have paid a heavy price in terms of undermining institutional learning.  FAST strategies deploy a learning architecture cutting across an entire organization. They also help to generate the productive friction required to drive and focus valuable learning.

Champions of institutional learning have often been their own worst enemies.  In their zeal for learning, they seem to say that all learning is good.  Well, that’s enough to make most executives cringe. There’s not enough time in the day to get work done – when is all this learning going to occur?

The real challenge is to figure out the answers to four questions:

• What learning is most valuable?
• When is it most valuable?
• How can this learning be most effectively tied to near-term operational performance improvement?
• How can this learning be spread throughout the organization so that its benefits can be amplified?

Effective strategy development is ultimately about focusing and leveraging learning across organizations.  In my experience, FAST strategies do this far better than other approaches.

For those who are interested in learning more about FAST strategies, I will be doing a webinar for Strategy World on Wednesday, May 9.   For more information, go here. I can assure you, it is not the approach to strategy you have come to know and love (?).

Complacency and Web 2.0

A number of recent events suggest a potentially significant evolution of Web 2.0 from a business perspective. Those who fail to notice these early signals may find themselves sidelined as Web 2.0 continues to unfold. 

Om Malik did a posting late last week on “Web 2.0: The End of Innocence” which nicely summarized some of these early signals:

The Web 2.0 story so far has been about taking APIs, mashups, low cost infrastructure and building applications that are then offered to customers for pretty much free, backed by an ad-supported business model. Think of this as the tie-dyed-free-love hippie phase. The Web 2.0 conference held in San Francisco in Fall 2006 was its Woodstock.

A lot of good things happened, innovation blossomed, but now we are entering a more pragmatic phase, where the large players like Google and Amazon who distributed the API elixir are taking control back.

APIs (Application Programming Interfaces, for my less techie readers) – especially open, standardized APIs – have been a key building block of Web 2.0, allowing one set of developers to leverage a growing array of functionality already available on the Web and bootstrap their way into delivering more value to Internet users. Rather than investing time on building applications or databases already available, developers have been able to focus on building truly distinctive functionality.

This has had a host of business implications.  It has dramatically reduced the investment required to establish an online service offering.  As a result, it has led to a proliferation of start-ups, all vying for audience attention (viral marketing diminishes in power as the viruses multiply) and, for those seeking to scale their offerings, investor dollars. For the large Internet players, Web 2.0 has been a great distributed innovation lab – watch and see what sprouts, then acquire the interesting players.

This has lulled many Web 2.0 entrepreneurs into a false sense of complacency.  Many, if not most, of the Web 2.0 start-ups are features masquerading as businesses. Business models? Fuhgeddaboutit! Their founders have little intention or ambition to build self-sustaining businesses – their exit strategy is to be acquired by one of the cash-rich gorillas. Business strategy: feed off the functionality of others long enough to get bought out, then start all over again. 

Well, recent actions by some of the large API providers like Google, Amazon, MySpace and Firefox suggest that there may be another, less welcome, exit – having the API rug pulled out from under you or, almost as bad, finding out that your friendly API provider has just introduced a service that competes directly with your own. Neither event is conducive to nailing that big acquisition exit deal. Apparently, the large Internet players are wearying of the high acquisition premiums for attractive Web 2.0 companies and are increasingly deciding to grow their own copy when they see an interesting venture.

Here’s the lesson that I draw from these recent events.  The only sustainable edge in Web 2.0, as in all businesses today, is to get better faster by working with others.  This isn’t a sprint where you can come out with a nifty new feature or service and then sit back until the buyer knocks on your door.  Web 2.0 is a powerful bootstrapping opportunity. It is most likely to pay off for those who take the resources available and rapidly build viable businesses with some reasonable barriers to entry – especially relative to the API providers you are bootstrapping on.

There are basically two ways to do this.  First, you can accelerate the innovation in the services you offer so that you are constantly one or two (or more) steps ahead of those tempted to copy you.  Second, you can find ways to use your service offerings to build trust-based relationships with your users, ideally with some powerful network effects that will make it very difficult for later entrants to pry these people away from your service. Ideally, these two approaches can be integrated by motivating your users to enhance your services themselves so that the more users you have the better your services become – the essence of Web 2.0.

In addition, you should explore the potential business trajectories of your API providers and try to make sure that you are not standing in their way.  At best, you want to be on the periphery of their field of play. When a supplier of anything decides to compete with its customer, it can be challenging for the customer.

For the large Internet API platform providers, there is also an important caution.  Sustaining a straddle between a platform business and an end-user business may become increasingly challenging.  If you become too greedy in terms of expanding into the end-user businesses of companies using your API platform, you may find that your platform business becomes less attractive. Before you start eating the young that are nourished by your APIs, you might want to be sure there are no other food sources to sustain you.

I suspect that sustaining the right balance in the Web 2.0 ecosystem over time will hinge on a new development – charging relatively nominal fees for API use.  This will put increasing pressure on API users to come up with viable business models and reduce the incentive for API providers to compete with their API users.

Magic and Fun with Emerging Technologies

Magic and fun – those are two words most people do not associate with today’s corporations.  Nevertheless, I came away from a recent conference more convinced than ever that these two words will become central to corporate performance.

I had the good fortune to attend Tim O’Reilly’s Emerging Technologies Conference in San Diego last week.  I spoke on the growing role of China in applying co-creation to physical products as diverse as motorcycles and consumer electronics.  In contrast to most conferences speaking engagements which are hit and run affairs, I was able to stay on and participate in a number of fascinating sessions. In the process, some interesting patterns and connections began to surface.

Magic – From magicians to enchanted objects

Magic – the theme of the conference, was inspired by a quote from Arthur C. Clarke: “Any sufficiently advanced technology is indistinguishable from magic.”  At first, I was skeptical, because I have always associated magic with illusions – very artfully done illusions, but illusions nonetheless. Also, magic is often associated, especially today, with magicians who specialize in displaying mysterious powers that mere mortals could not hope to possess – we can only watch in awe and show our appreciation with applause.

As the discussions unfolded, though, I began to see another perspective on magic, one that focuses on pushing the frontier of performance and capabilities beyond levels that we expect and that therefore appears to be “magic”.

Mike Kuniavsky in his presentation on "The Coming Age of Magic" in particular focused on the role of “enchanted objects” that embed unexpected performance and capabilities in everyday, familiar physical objects that becomes tools for everyone to use. As computing and communication resources become more widely embedded into everyday objects, we see the potential for “enchanted objects” to surface in the most unexpected places. Rather than relying on professional magicians, this approach seeks to empower everyone with access to these tools. Mark Weiser’s “ubiquitous computing” vision leads to the dissemination of magic in all areas of our life and to all people who have access to these objects.

By the way, when we think of enchanted objects, we should not neglect our physical bodies as another great presentation by Quinn Norton on “Body Hacking” made clear. Quinn was particularly interested in the opportunity we have to use technology to push the frontier of performance and capabilities of our physical bodies. Of course, our ability to fully exploit this potential hinges on societal norms and the degree to which we can assert the rights required to hack our bodies.

Hard fun

So far, this is interesting, but what really got me intrigued was the connection between magic and fun, triggered by a great presentation by Raph Koster on "The Core of Fun".

Raph was the lead designer of Ultima Online, one of the early massively multiplayer online role playing games, and a deeply thoughtful analyst of game design as revealed in his book, A Theory of Fun for Game Design.

His talk discussed the deep, fractal structures that underlie all forms of entertainment, including games.  He differentiated four different classes of fun – hard, easy, visceral and social – and suggested that games focus on “hard fun”, where the challenge is solving problems and mastering new techniques. What struck me is how analogous this challenge is to business in general, especially if you believe that the only sustainable edge comes from getting better faster than others. I won’t attempt to reproduce the richness of his presentation here, but instead wanted to pull back and reflect on its relevance to the broader business world.

We are all under growing pressure to get better faster.  In a previous posting, I reflected on the role that games can play in terms of acquiring skills and even shape one’s dispositions to the world.  But Raph’s presentation got me thinking – maybe the real opportunity is to more consciously structure our working environments along the gaming principles of “hard fun”. 

Listen to Raph’s basic principles and apply them to the broader challenge of building capabilities in the business world – core actions have to be repeatable, they have to require skill, they have to be able to handle statistical variation to facilitate learning, they have to be competitive, they have to provide ladders to climb and things to see, everything you did before must matter (never start an interaction without context), users should be able to solve the challenge with their choice of tools, results have to be highly visible to everyone and the best feedback is a greater challenge.  (Note, these are just some of the principles covered by Raph, but they give a sense of where he is headed.) 

Bottom line, Raph observed that “low risk activity for high reward is bad for fun”, “you need to drive users to challenges at the edge of ability” and “fun does not exist where you have zero consequences.” My key takeaway from his talk was that you enhance fun by providing a sequence of escalating challenges that push you to the edge of your capabilities (but not beyond them) with flexibility in terms of how to respond to these challenges and appropriate and visible rewards for succeeding. Now, what if we reconceived our business operations with “hard fun” and learning as the primary objective rather than simple efficiency?

JSB and I have talked about the transition from push programs to pull platforms as a key force re-shaping our business landscape.  In hearing me talk about this, many executives tend to get excited about the flexibility that pull platforms provide in responding to unanticipated event. From my perspective, though, that is only a small part of the rationale for this shift – the big reason to make this shift is to provide a robust learning environment for participants so that they can improvise, tinker and bootstrap their way into greater capability. Raph’s principles cannot be applied to business environments without a shift from push programs to pull platforms. His principles then provide a set of guidelines for institutions to maximize the learning that can be achieved through the use of pull platforms.

Adding in the social context

Talking about fun and gaming and the mixing of virtual worlds and real worlds leads naturally to Jane McGonigal’s great talk on “Creating Alternate Realities” addressing the opportunity for technologists to become happiness hackers. McGonigal is also a noted games designer and games researcher. Once again, I’m not going to try to reproduce the richness of her provocative talk (in particular, don’t miss her insights about integrating virtual and physical worlds in game design) but instead I’ll zero in on her comments on the “science of happiness”. Building on the work of a growing number of researchers in this field, Jane highlighted three different realms of happiness:

• pleasure – satisfying experiences
• engagement – immersive, responsive systems
• meaning – a powerful role, as actor and observer.

Tying this back to Raph’s talk, I heard him as primarily focused on pleasure and engagement, but not spending enough time on meaning as an element of fun, especially as it highlights the social dimension of building connections and relationships with others.

We construct meaning and roles in a social context.  Once again, executives often misunderstand the role of pull platforms – they tend to view these platforms as interesting ways for people to access and mobilize the physical resources they need.  They miss the fact that pull platforms are designed to help people connect and collaborate with other people in ways that are very difficult to anticipate in advance and in ways that accelerate learning through these interactions.  Danah Boyd’s talk at the conference on “Incantations for Muggles” focused on the need to pay more explicit attention to social architectures and the impact that technology can have in re-shaping and amplifying these architectures.  As JSB and Paul Duguid remind us in The Social Life of Information, learning occurs in a social context. We cannot hope to accelerate learning without an explicit consideration of the social context and the ways that it both inhibits and enhances learning. If there was one area that the conference did not adequately develop, it was this social dimension of magic.

Summing it up

There you have it – my grand synthesis of four days of extraordinary and stimulating sessions: magic, in the sense of pushing the frontiers of performance and capabilities beyond expectations, requires an integration of three very different elements – environments architected to foster “hard fun”, enchanted objects to amplify the capabilities of mere mortals and platforms to foster collaboration with others to get better faster than anyone possibly could on their own. Bring these elements together in a reinforcing way and magic happens. While this form of magic was largely discussed in the context of games and consumer life, it is highly relevant to business challenges as well. In fact, I would go so far as to assert that our ability to apply this kind of magic and fun in our enterprises will make the difference between the companies that survive and thrive and those that fall by the wayside.

As an aside, magic and fun most frequently occurs on the edge. The challenge for institutions of all stripes is to import this magic and fun into the core.

This is the real promise of Web 2.0 – not just creating environments where applications and data harness network effects but where people and institutions harness network effects to get better faster.  From my perspective, the missing element in Web 2.0 is the opportunity to go beyond applications and data and harness technology to accelerate talent development. Now that would be magic.