Why gurus should cross the bridge into business

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Michael Porter’s models were based on a tool for industrial policy, not strategy. Now economists are beginning to understand the workings of firms as well as industries.

On the North bank of the Charles River lies the academic city of Cambridge, Massachusetts. To the south lies the busy metropolis of Boston. Around twenty years ago, a young man crossed one of the many bridges which span the Charles River. He carried in his briefcase the plans of his former employer. These he hoped would form the basis of his future career in the rich but demanding environment to the south. Discarding all evidence of his previous identity, he found succour in an office in Soldier’s Field. His gamble paid off. Within a few years, he had found fame and fortune beyond the dreams of most of his former colleagues.

The young man was Michael Porter. The institution he left behind was the economics department of Harvard University. The institution in which he took refuge was the Harvard Business School. The plans he brought with him described what had become known as the structure-conduct-performance paradigm (SCP). The fame and fortune which followed are well known.

The structure of SCP is shown in Figure 1, drawn from what still remains its bible, the magisterial survey by F.M. Scherer. Figure 1 begins from the basic conditions of supply and demand which any industry faces. The SCP paradigm asserts that these conditions determine the structure of the market and industry, and that the competitive conditions which result influence the behaviour of firms and dictate the performance of the industry. It provided – and still provides – a coherent framework which permits a logical ordering of the many influences on industries and markets.

SCP explains how structure influences conduct and performance. Its criteria of performance are the criteria of public policy: full employment, efficiency and equity. A business analyst would look at the norms of business success – profits, revenues,. market shares. But these are not what interest Scherer. He and his former Harvard colleagues found themselves much in demand as advisers to government, particularly in the anti-trust division of the Department of Justice. But they were only rarely consulted by senior executives.

Now if they had been consulted by senior executives, there would have been severe constraints on what they were able to say. Because another feature of the SCP approach is that it fails to explain, or even to address, the central question of business strategy. Why do some firms do better than others, operating in the same environment? If two firms each face the same basic conditions of supply and demand, if both firms operate with the same market structure, why should there be any?

Porter’s achievement – in his first book, Competitive Strategy was to address the first of these problems. He rewrote the SCP framework in terms which were directed at,. and accessible to, business people. The affinity between the SCP framework of Figure 1, and Porter’s famous five forces (Fig. 2), is immediately obvious. Industrial economics had become business strategy.

But Porter’s translation did not resolve, and could not resolve, the second and more fundamental weakness of the SCP approach. Why did some firms manage the five forces better than others? That is why Porter’s framework is much more successful in his first book – Competitive Strategy – which is mostly concerned with the structure and behaviour of industries and markets than it is in his second – Competitive Advantage – which attempts to focus more closely on the issues which affect individual firms. It is ironic, but hardly surprising, that in his third work – The Competitive Advantage of Nations – Porter had reverted to the traditional concerns of Harvard economists. That book is mostly directed to public policy. And to do so he trawled back to the concepts of an even earlier generation of economists. It was Marshall and Pigou, from Cambridge England, who had first described the growth of industries and markets by describing clusters of firms and who had emphasised the importance of external economies – cost advantages which arise when many firms succeed in the same industry.

But while Michal Porter was teaching strategy on the Boston side of the Charles River, something new was happening on the other bank. They do not teach the SCP paradigm in the Harvard economics programme any more. SCP has given way to a new style of industrial economics. An industrial economics that emphasises topics such as asymmetric information – how markets work, and often don’t work, when sellers know more about what they sell than buyers about what they buy. It uses game theory to understand how small groups of competitors interact. It deals with contracts, relationships, and describes how incentive structures influence the behaviour of principals and agents.

And in Cambridge, England, an economist called Edith Penrose had laid the basis of the resource based theory of strategy. In it, firms are not – as they are in SCP and the five forces – black boxes whose internal workings are unexplained. They are dynamic collections of capabilities. For the first time, there was a theory of the most important economic fact of the last century – the existence of large firms.

But mostly, the new economists wrote in mathematics, preferring the esteem of their peers to the rewards of the business guru. Still, the rewards of the guru are not to be sniffed at. Perhaps a few more people should cross the river?

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