In Praise of Walls

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In recent years, a vocal school of business experts has argued that leaps in information technology have made possible a new world of seamless collaboration among businesses, one that will bring enormous gains in efficiency and flexibility. Indeed, the experts counsel, executives should look for opportunities to tear down the “walls” a round their organizations, merging their companies into great, amorphous “enterprise networks” or “business webs.” Like other utopian visions, however, this one is full of hidden dangers.

It’s true, of course, that computer networks in general and the Internet in particular have made it easier for companies to share information about supply and demand, to blend their processes and to outsource more and more activities. Such efforts can enhance industry productivity by removing the friction from business transactions. But they also have the potential to undermine a company’s distinctiveness and hence, in the long run, its profitability.

Senior managers, then, face a central strategic challenge: They must defend their companies’ competitive advantages — many of which were built, in one way or another, on the proprietary control or distinctive use of information — while at the same time allowing information to flow freely in and out of their organizations through the general IT infrastructure that has been developed over the past decade. As they consider this task, they should bear in mind that new technologies will never conquer cutthroat competition. Companies will always need the walls they have so carefully erected over the years to protect their advantages.

The Coase Effect

The postcompany school has made some radical claims that may, given discussions of “coopetition” and the realities of ever increasing outsourcing, resonate with many managers. One of the most avid proponents of this concept, business consultant Don Tapscott, has gone so far as to herald the death of the stand-alone company as the fundamental unit of commerce. In a 2001 Strategy+ Business article entitled “Rethinking Strategy in a Networked World,” Tapscott argued that “in the future, strategists will no longer look at the integrated corporation as the starting point for creating value, assigning functions and deciding what to manage inside or outside a firm’s boundaries. Rather, strategists will start with a customer value proposition and a blank slate for the production and delivery system.” Such an approach goes far beyond current conceptions of outsourcing, Tap-scott stressed: “There will be nothing to ‘out-source’ because, from the point of view of strategy, there’s nothing ‘inside’ to begin with.” Two other consultants, Larry Downes and Chunka Mui, put it more concisely in their best-selling 1998 book Unleashing the Killer App: “A truly frictionless economy needs no permanent firms.”

The postcompany school has adopted the economist and Nobel laureate Ronald Coase as its high priest. In his brilliant 1937 essay “The Nature of the Firm,” Coase explained why companies exist in the first place — why, in other words, it makes sense for some business activities to be coordinated by managers within a formal, hierarchical organization rather than by the marketplace’s invisible hand. “The significant question,” as Coase put it, “would appear to be why the allocation of resources [within a company] is not done directly by the price mechanism [of an open market].”

Coase’s answer was that markets impose various transaction costs over and above the actual price of a purchased good or service. If a company decides to use an outside supplier to perform a particular activity, it has to search for and evaluate potential vendors, decide on terms and draw up contracts, collaborate in making decisions and fixing problems, monitor the supplier’s performance, assume the risk of the supplier’s failure, and so forth. But if it carries out that activity itself, using its own employees, it can often reduce or avoid these costs. A company will, therefore, expand its organization to encompass any activity that it can carry out more cheaply than the total of the market price for performing the activity plus the attendant transaction costs. More generally, companies will tend to get bigger as external transaction costs increase and to shrink as they decrease.

The members of the postcompany school, seeing that the Internet has reduced certain transaction costs, particularly those related to exchanging information, jump to the conclusion that companies will naturally get smaller. They then make a further logical leap: As communication costs continue to fall and the integrative power of the Internet grows stronger, many business activities will eventually be organized through markets, without any centralized control. Industries will begin to adopt the Hollywood model of production: Teams of specialists will come together to create a particular product or carry out some other business function and will then disassemble and reassemble in new ways, as market forces dictate. Managers and companies in the traditional sense will disappear entirely, as Bill Gates’s vision of the Internet as “universal middleman” comes to fruition.

But this is a misreading of Coase. It’s true that the Internet reduces transaction costs within markets, but at the same time it reduces coordination costs within companies. In other words, it makes management itself more efficient, which can make it possible for even more activities to be incorporated economically within a single organization. As Berkeley economist Hal Varian noted in a perceptive 2002 New York Times article, Coase took pains to point out the complex effects of innovations that influence transaction costs. “Most inventions,” Coase wrote, “will change both the costs of organizing [within the firm] and the costs of using the price mechanism. In such cases, whether the invention tends to make firms larger or smaller will depend on the relative effect on these two sets of costs.” He then got more specific, in a way that has a direct bearing on understanding the Internet’s impact: “Changes like the telephone and telegraph which tend to reduce the cost of organizing spatially will tend to increase the size of the firm. All changes which improve managerial technique will tend to increase the size of the firm.”

History eloquently underscores Coase’s point. Earlier infrastructural technologies that reduced communication and coordination costs — not just the telegraph and telephone but also the railroad and the automobile — did not lead to smaller firms. Just the opposite, in fact: They brought into being giant, vertically integrated companies and made the complex modern business organization possible. It is dangerous to assume that the “death of distance,” to borrow journalist Frances Cairncross’s description of the effect of new communication technologies, will mean the death of the company. In some cases, the Internet will lead business organizations to shrink by making it economical to outsource more work. In other cases, it will lead them to expand by making it cheaper to bring more tasks inside.

The Unplugged Version

There are other reasons to believe that corporate walls, real and virtual, will not and should not come tumbling down anytime soon. For example, a professor of IT management at Harvard Business School, Andrew McAfee, has suggested in a recent paper that information technology may increase the relative cost of using the market to coordinate work. In the future, he argues, efficiency gains will hinge on the coordination of complex, highly automated vertical processes, such as the management of a supply chain or a distribution system. That coordination in turn will require the rigid standardization of processes, data and information systems. It is often much easier, McAfee points out, for centralized management to impose such standardization on an organization than to wait for it to emerge organically through the complex and often conflicting interactions of free agents in a marketplace. Hierarchies, in other words, may outperform markets when it comes to integrating complex information systems, leading to a reemergence of the vertically integrated company.

But beyond the practical economics, there can be important strategic reasons to keep diverse activities under the direct control of management. Any outside contractor will have its own economic incentives, which may or may not coincide with those of the company that hires it. It’s fine to talk about “win-win partnerships” and “enlarging the pie,” but in the end all companies in an industry are in competition to seize larger shares of the industry’s profits for themselves. When a contractor’s economic incentives diverge from those of the company that hired it, the contractor can be expected to act in its own interest, even if that brings harm to its partner. As Varian put it, “If certain suppliers are critical to your success, you want them inside, under your control, not outside, where their objectives may differ from yours.” Even when it costs less to outsource an activity, you might not want to do it — the strategic risks may outweigh the cost savings.

What’s dangerous about the postcompany theorists’ argument is its obliviousness to the competitive realities of business. They would have companies turn themselves into specialized modules in broad “plug-and-play” business networks. As Richard Veryard puts it in his 2000 book The Component-Based Business, “Thanks to the plug-and-play approach, a new business can be rapidly assembled as a loosely coupled set of partnerships and services. … Even a substantial company can now be viewed as a component of a much larger system, rather than as a self-contained business operation.”

Such a view reveals a common shortcoming in the thinking of technologists: their tendency to confuse business with information processing, to want to see companies as, in essence, glorified computers. They overlook, or give short shrift to, the physical and human characteristics of commercial organizations — all the things that can’t be reduced to digital code, that can’t be “made transparent” through networks. This skewed perception underpinned the hype about electronic markets in the late 1990s, and it continues to inflate expectations about Web services, business-process management and other IT developments. It leads to the conclusion that companies, like computers, can and should become components or modules in broad and flexible networks. But as the history of the IT infrastructure itself shows, becoming a standardized module often means becoming a commodity — anything that can easily be plugged in can just as easily be unplugged.

In the end, standardized, modular companies would have fewer ways to distinguish themselves; the evaluation of their performance would be reduced to a few easily compared measures. In many cases, this would leave only one basis for competition: the price at which they can carry out their specialized function. For many companies, participation in a seamless “business web” would virtually guarantee a profitless existence.

No Substitute for Strategy

Despite these warnings, companies should not go to the other extreme and pull back into their shells. Figuring out how broad or narrow a role to play in an industry’s value chain has always been, and will always be, a central strategic decision. In assessing potential partnerships or outsourcing opportunities, managers must be careful to keep their own companies’ interests foremost. Smart companies will resist knee-jerk specialization and modularization, recognizing that such approaches may undermine the complex advantages on which true long-term success is founded. Instead, wise companies will use the IT infrastructure to establish business relationships that enhance their own economic and strategic power while also providing meaningful incentives for their partners.

The postcompany school gets it half right, then: The universal IT infrastructure does create pressures to homogenize business processes and organizations. But this doesn’t mean that companies should give in to the pressure. Managers need to be wary of alliances, contracts or initiatives that foreclose opportunities for advantage and put long-term profitability at risk. They must defend their companies’ integrity as stand-alone businesses even as they exploit the tighter connections to other companies made possible by computer networks. As ever, the worst thing a business leader can do is to go with the flow.


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