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October 3, 2004
David Warsh, Proprietor


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The Sea Otter, and Other Cautionary Tales

The Enron debacle continues to be a real mystery.  Sixteen years from the purchase of a little gas transmission pipeline company to become seventh largest American corporation among the Fortune 500? Some $100 billion in revenues?  How did that company fool so many people so completely?  How did things go so wrong?

An intriguing answer has been suggested by Harvard Business School professor Marco Iansiti and management consultant Roy Levien. It is a mistake to believe that shady dealings caused the failure, they say.

Instead, the executives who built Enron had tumbled on to a business model that had been pioneered successfully by Wal-Mart and Microsoft, among others. It was quite new and not yet fully understood, and, failing to understand it completely, they executed it very poorly.

The fact that they turned out to be crooks as well only made matters worse.  It was incidental to their failure.

And what is that new business model?  A network, of course.  A particular kind of network.

That’s what The Keystone Advantage is about.  The subtitle is “What the New Dynamics of Business Ecosystems Mean for Strategy, Innovation and Sustainability.” Goodness knows that a great deal of consultant fog comes packaged this way.

But real progress in understanding networks and how they evolve has been unfolding in the business schools. Witness the appearance in recent years of books such as Lean Thinking, Real Options, Clockspeed, Information Rules, Design Rules, Strategy Maps. This isn’t what you’d call economics, but it is disciplined thinking tending to where economics eventually must go. Keystone might be the most suggestive version yet. And in the meantime, it is very good advice if you have a business to run.   

“Strategy is becoming, to an increasing extent, the art of managing assets one does not own,” the authors begin. This is because complex networks of firms and products have become an increasingly common feature of the business world — not just high tech industries such as computers and semiconductors, but apparently low-tech businesses such garment manufacture.

A prime example, they say, is Li & Fung, a hundred-year-old Hong Kong-based trading company that performs supply-chain management for more than 8,000 companies in forty countries.  The authors describe how in order to produce a line of garments for an American retailer, Li & Fung might “purchase Chinese yarn that was woven and dyed in Thailand, send the fabric to be cut in Bangladesh, ship the pieces for final assembly to South Korea (where the garment would be matched with Japanese zippers), and finally deliver the finished products to various geographically-dispersed retailers at the appointed time,”  all the while practicing sophisticated load-balancing and risk management techniques, thus providing lower costs, faster delivery and the latest techniques to its customers — a virtual Wal-Mart for the manufacturing class.

Or consider IBM. The story of its famous 360 line of business computers by now is fairly widely understood, thanks to Kim Clark and Corliss Baldwin’s Design Rules. Faced with runaway complexity in its product line in the mid-1960s, the company invented the information-age equivalent of interchangeable parts — modular computer architecture, with the interface between hardware and software so clearly defined that many various building-blocks could be assembled as systems and expected to work smoothly together.

Soon the notion of platform emerged, meaning operating software for which, thanks to its well-defined interfaces, any number of developers could write general-purpose applications that would run on many different kinds of hardware. IBM found itself the hub of a rapidly-expanding network of makers of various peripheral products — until emergence of the personal computer in the Ô80s enabled Microsoft to take control of a new platform (the Windows operating system, following MS-DOS) and displace IBM at the center of a much more extensive network.

Such an interdependent, rapidly-evolving industrial setting bears a strong resemblance to ecosystem, according to Inansiti and Levien — a large number of loosely-connected individuals who depend on each other for mutual effectiveness and survival.  And so they borrow a number of concepts from ecology to describe how these complex systems work, or fail to work.

Chief among these is the notion of a keystone species.  The term was coined by University of Washington zoologist Robert Paine in 1966 to describe a species that has disproportionate impact relative to its abundance (in a paper titled “Food Web Complexity and Diversity”).

Everyone has a favorite example — the sea otter, in Iansiti and Levien’s case.

During the 19th century, the Pacific Northwest sea otter was hunted nearly to extinction for its fur. Gradually settlers noticed a wide variety of fish and near-shore plants disappearing. In due course, biologists supplied the reason why:  the sea otter was the only (non-human) predator capable of controlling the sea-urchin population. Sea urchins, left free to breed, had overgrazed the kelp that supported a wide variety of in-shore populations.  The recent reintroduction of sea otters has begun to restore some of the dish, invertebrate and plant complexity.

Sea otters are a keystone predator, the authors note; though a tiny part of the ecosystem, they are effective because they eat so much.  Kelp, on the other hand, is a dominator species because there is so much of it. Its very abundance helps keep things in balance. In each case, however, the species provides a platform on which a complicated foodweb is built.

In the business domain, however, a classic dominator can too easily pursue a landlord strategy, eschewing openness in order to pursue control — rather like seaweed choking the life out of a pond by sucking up too much of a vital nutrient. (Chapter two of The Keystone Advantage features an illuminating discussion of the zebra mussel in the Great Lakes!)

A third kind of species in the ecological literature is the niche species.  Collectively these specialists form the bulk of any particular ecosystem, though individually they do not widely interact.  “Keystones shape what an ecosystem does,” write Iansiti and Levien, “whereas niche species are what it does.”

Keystone-like behavior is not confined to the natural world, say Iansiti and Levien.  Business firms exhibit it too. Just as in natural systems, keystone firms perform a number of important services to the communities of which they are part.  For one thing, keystone firms displace or hold in check firms that otherwise might take over an industry through a dominator strategy — IBM-Microsoft-Intel forcing Apple to open up its highly integrated approach to personal computers, for example.

They also serve as a buffer, preserving continuity while non-keystone species change around them. A case in point, they say, were the successive waves of transformation of the software industry, with Microsoft, IBM and Sun adapting to the rise of the PC, the graphical user interface and the Internet, all the while maintaining the overall structure and productivity of the industry, while innumerable smaller firms (Digital Equipment, Apple, AOL) rapidly soared and subsided around them.

Just as in an ecosystem, then, a business domain thrives if firms are healthy. But if significant players in an industry are out of balance or unhealthy, then the entire domain may suffers.  Such is the shared fate of business networks.

And that, it turns out, is the point about Enron. The firm was seen to be pursuing a keystone strategy — a master of the “asset light” approach that would turn out to be the next Wal-Mart, or Microsoft, or Li & Fung. It enjoyed a reputation as an innovator, for having successfully entered the deregulated market for gas. It seemed to understand the importance of occupying critical hubs in the various industries that it entered, one after the other — electric power, Internet bandwidth, pulp and paper, water, weather derivatives.

But its understanding ended there. Enron was a faux keystone, the authors write. In fact, the company pursued an extreme form of the landlord strategy, egged on by the stock market and the business press, extracting unsustainable amounts of value from its transactions, ignoring and even actively damaging the health of the networks it served.  Its celebrated Enron Online trading platform turned out not be a vehicle on which others could build, as is,  say, Wal-Mart’s Retail Link database; rather it was a means of outfoxing its customers by  concealing pricing information while boasting of its transparency. Enron wasn’t about sharing information, reducing complexity or creating stability, the authors say; it was about inventing new ways to game the market. 

The worst part is that there is reason to believe that Enron didn’t even know what it was doing, say Iansiti and Levien. “All too often executives in organizations ranging from AOL to Enron simply had no understanding of how some immediate decision they had to make could have an impact on companies they did not even know existed.”

It wasn’t just the well-publicized trading strategies that were devised by anything-goes its traders to fleece its customers — “Megawatt Laundering,” “Daisy Chain Swap” and “Death Star.”  It was Enron’s utter disregard for everyone else in the industry — including competitors who might have provided a check on its ruthless and self-destructive behavior.

Such executives thus are perhaps a little like the fur traders who nearly extinguished the sea otter in the Pacific Northwest. All the more reason, therefore, for strategists and economists to pursue the ecological and evolutionary perspectives in the coming years.

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