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Challenging the Theory of the Firm

In this world, the traditional view of the firm no longer serves us well. Adam Smith’s famous pin factory, Henry Ford’s automobile plant, and Peter Drucker’s General Motors have defined how we think about management and strategy. The corporation has been at the center of management study and thinking since the birth of modern business research and education. Our management textbooks are built around the firm. Our laws are based on the corporation. And yet the traditional firm is increasingly an anachronism in a world of diverse and fluid connections—a networked world. New technologies and new business models have transformed the corporation.

The focus of the traditional theory of the firm was on “transformational efficiency” and market power, purchasing inputs and transforming them efficiently into products and services that could be marketed profitably to the firm’s customers. The firm and the efficiency of its transformational processes, and its ability to command premium margins in the market, were the focal points of strategy. What has happened in the unbundled economy of the twenty-first century is that this “corporation as king” model has given way to a much more complicated array of interorganizational systems for innovation, for production, for marketing, and ultimately for connecting with customers and investors. On the supply side, outsourcing, offshoring, and the Internet have led to new connections to provide a variety of services, from accounting to manufacturing. On the demand side, open architectures and empowered consumers are driving both innovation and customization of existing products and their marketing. In the process, many corporations have come to view their profits and their risks not in terms of what they control internally, but in terms of their relational capabilities to the networks in which they are embedded.

These networks have done more than connect nodes of independent companies. They have led to second-order and third-order effects that are absent from bilateral transactions. Networked enterprises raise issues of group influence, cascading, contagion, and interdependent risks that cannot be controlled through standard mechanisms. As shown by eBay and other new business models, the distinctions between companies and markets have been blurred. Some of the challenges of the networked world cannot even be considered from a firm-level perspective, any more than a complex ecosystem can be understood by studying one of its actors, or a chemical reaction can be understood by studying a single reagent. The rise of networks has fundamental implications for business strategy and competencies.

Strategy and Competencies

Business strategy has been built around the firm. Michael Porter’s (1985) famous Five Forces model puts the firm at the center, and other forces outside. Now the firm is part of the network and the five forces are in the network itself. Concepts such as barriers to entry have less meaning, and the idea of rivalry, buyers, and suppliers is transformed by an environment of “co-opetition” (Brandenberger and Nalebuff 1997).

Core competencies also look different from a network view. Since Hamel and Prahalad identified the importance of core competencies, these competencies have been primarily discussed at the firm level. Companies focused on building and protecting competencies that could not be easily imitated by rivals and could be leveraged across different businesses (such as Honda’s expertise in small engines used in products from motorcycles to snowblowers). But as the world has become more networked, the competencies that are important are not so much the ones a company owns as the ones it can connect to.

New technologies, as discussed by Thomas Friedman (2005), are flattening the world. A small village in China or a tiny shop on the back streets of Mumbai can tap into global networks to identify current bids for its products or purchase manufacturing inputs, competing on a relatively level playing field. Entrepreneurial startups can compete against large, well-funded incumbents. Consumer products firm Method (www.methodhome.com), for example, worked with a network of global partners to build a $100 million business in just a few years, competing effectively against giant rivals such as Procter & Gamble. An amateur with a video camera can create content that can compete with large entertainment firms. Large companies can partner with these smaller firms, drawing together swarms of bees into a single productive hive. The challenge for large companies is to develop network-centric business models and strategies to harness the power of the broader network and harvest its usufruct (the right to derive benefit from property that belongs to another person as long as the original property is not damaged).

A Time of Revolutions

The rationale for the firm as an economic and legal entity finds its roots in the very beginnings of modern economics. The cornerstone of this view is Adam Smith’s great treatise, The Wealth of Nations, published in 1776 on the eve of the birth of the American Republic. It was motivated by Smith’s view that the changes that were beginning to be visible in the textile and manufacturing sectors of Britain would transform the economic activity of the world. A new theory was required to think about this. His theory saw economic value as being driven by two fundamental economic factors: “specialization” to achieve economies of scale, and “trade” to rebundle into useful products what specialization had unbundled.

We stand again in a time of revolutions. In the Internet age, the unbundling and rebundling foreseen by Smith has been facilitated by new communications and information platforms. Many of the nontechnical barriers to trade are being dismantled by regional innovations such as NAFTA and the European Union, and by supranational organizations like the WTO. China, India, and other emerging economies are growing rapidly in an interconnected world. Dubai and Abu Dhabi are planning their growth based on serving as a hub for countries within an 8-hour flight. In networked enterprises, the clear lines of specialization and trade have become blurred along with the lines between enterprises.

Perhaps the modern equivalent of Smith’s pin factory is Li & Fung in Hong Kong. For a company that produces more than $9 billion in clothing, toys, and other products for some of the world’s leading brands, a competency in manufacturing might be considered to be central. Yet the company does not own manufacturing plants or employ seamstresses. Instead it orchestrates a network of thousands of suppliers around the globe to create supply chains on-the-fly. Its core competency is not in specialized manufacturing process. Instead, its most important competency is in designing and managing the overall network, what company leaders Victor and William Fung call “network orchestration.” This is its area of specialization.

Peter Drucker, exploring the depths of what was the twentieth century’s quintessential modern corporation, General Motors, led the way into an understanding of modern management principles that still shapes the way managers are educated and practice. Today, General Motors offers a case in point about how the world has changed fundamentally. It has struggled to keep up with rivals, such as Toyota, with more skill in managing networks for innovation and operations. This new networked organization is, to echo the words of GM’s infamous advertising campaign of the late 1980s, “not your father’s Oldsmobile.” The past two decades have seen immense changes in the forces and institutions that govern economic activity. These changes are leading to a new theory of the firm.3

Revolutionary times can be quite dangerous. While networks present opportunities, they also raise a number of risks and challenges as exemplified by the discussion of the financial crisis and the tainted-milk problem that opened this chapter. We have seen waves of change in governance, enterprise risks, and social structures. There are concerns about political risks from corruption, nonstandard accounting practices, and discriminatory regulation in international transactions (www.opacityindex.com). Accountability and transparency can be lost in the complex web of networks. We face network threats of terrorism, diseases, and global warming. These risks are the downside of the opportunities reflected by the network revolution. This revolution has provided huge increases in access to resources and markets, enabled by networks. The same revolution has exposed companies and economies to new complexities and risks because of the increased interdependencies implied by networks. Navigating and balancing the trade-offs between these opportunities and risks is the central challenge for management posed by the new age of networks.

Nodes and Networks

Companies were once seen as self-contained nodes connected with other enterprises; they are now increasingly an integral part of networks. New technologies and logistics platforms have allowed for the unbundling of the vertical organization. This is changing relationships of companies with one another, their employees, customers, and other stakeholders. What happens across organizations is often more important than what happens within them. This transformation and its implications for managers and researchers are the subject of this book.

As our attention shifts from companies to the white space and relationships between them—like the famous optical illusion that shifts from two faces to the vase contained between them (see Figure 1-1)—we need a more fundamental rethinking of our view of business. These dramatic shifts mean that we need to challenge our traditional mental models of management (Wind and Crook 2004). Holding to old models that no longer fit the environment can lead to missed opportunities or the failure to see potential threats.

Figure 1-1

Figure 1-1 Node or network? Two faces or a vase? As our focus shifts from the firm (nodes) to the network, the white space between enterprises has become increasingly important. Is it time for a shift in our view of strategies and competencies?

The node and network exist together. The faces and the vase are both there, so sometimes it makes sense to look at the firm, sometimes the network. The fortunes of companies still rise or fall based on their own earnings and stock performance—not the strength of their networks—although networks are playing an increasing role in their performance. Investors still buy stock in companies, but the extraordinary valuation of a company such as Google depends in large part on the network in which it is embedded. Like the wave or particle theory of light in physics, both the node and the network view have a place in explaining the phenomenon of our current business world. In particular, the success or failure of many modern enterprises cannot be well understood at the firm level. They demand a network view.

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