I’ve just finished reading The Lords of Strategy by Walter Kiechel and it is terrific.  It is 333 pages long and I read it in one day – if you overlook staying up until the early morning to finish it. If you are at all interested in business, read it. But I can summarize in one sentence its main message:

The difference between business today and as it was in the 1960s is immense and the difference is the strategy paradigm.

Or if you give me one more sentence:

The difference was due to one man and one firm, started in 1963.

Or yet another:

America, China, and the world would be a lot less prosperous today but for the strategy paradigm.

I’m aware that using the word “paradigm” is a way of losing readers – the less cerebral ones, anyway – so let me swiftly explain.  Please listen up because it could be the difference between your personal success – if you are in business – or failure.

What is the Strategy Paradigm?

Frequent readers will know that “paradigm” was a highly recondite word before Thomas Kuhn wrote The Structure of Scientific Revolutions in 1962.  Afterwards “paradigm” became popular, banal, and debased, but I am using the word in a Kuhnian sense.  A paradigm is an accepted model or pattern, a scientific theory that becomes dominant and excludes any other theory related to the same subject, until it is replaced by another paradigm.

For example, the theory that the sun revolved around the earth was the dominant paradigm until Copernicus (and for many years after too), until it was replaced by the new paradigm that the earth revolved around the sun and was far from the being the center of the universe, which has lasted as the dominant paradigm for several centuries.

Other new paradigms were propagated by Newton, Lavoisier, Darwin, and Einstein. They changed scientific theory and had practical consequences, such as nuclear power and bombs, the computer, space travel, and the internet.

In other words, paradigms are rare – they are a big deal.  They explain something simply and in a way that is consistent with the evidence, more or less; and more than any other competing theory.

Not every important scientific or other domain of knowledge has a dominant paradigm, one that is generally accepted by all practitioners at a particular time.     I am not a philosopher, and stand to be corrected, but I don’t think there has ever been a dominant philosophical paradigm.  Instead there have always been competing theories, which have changed over time but never enough for one theory to emerge as dominant.  There is no dominant paradigm in politics, economics, psychology, sociology, or pretty much any of the social sciences.  There are fragments of theory but no overall perspective into which all the evidence slots neatly enough to make sense to everyone.

The absence of a dominant paradigm is a big problem. It means that the experts keep contradicting each other, and the rest of us remain confused as to what exactly we should do to be happy and successful.

So what have been the dominant paradigms in business?

I think there has only ever been one.

Before 1963, there were fragments of theory related to business, but no overall accepted theory.

In the eighteenth century Adam Smith made contributions with a few vital conceptual frameworks – the ‘invisible hand’ of cooperation and competition beloved of free marketeers; the idea that the size of the market was limited by the high cost of goods and could be made unlimited by specialization and scale, which reduced costs and so enlarged the market; and the observation that merchants and manufacturers were always conspiring to establish an oligopoly or monopoly in order to keep prices and profits high.  While these insights were incredibly valuable, they did not work together to give an integrated theory of business which could be followed by entrepreneurs and governments alike.

In 1817, David Ricardo came up with the theory of comparative advantage, which said that nations should concentrate on those industries where they have the greatest advantage, or least disadvantage, relative to other nations.  Portugal might not be the lowest cost or highest quality producer of wines, but if the difference between Portugal and the country best at producing wine was small, wine would be a better bet than say cotton and clothing, where England had a huge advantage over Portugal (you can see why the English liked this theory).  Although there are some conceptual flaws, the theory of comparative advantage was the bedrock of the policy of free trade, which has done more to increase the wealth of nations than anything else except Adam Smith’s theory of capitalism.

But for business, there was no accepted dominant overall theory.  Capitalists argued with socialists and communists.  Business people did not know what they needed to do to increase their own wealth and that of their customers.

The best pioneers, such as Henry Ford, were interested in both theory and practice.  “Fordism” became both a political and economic theory, extolling the virtues of industry scale and specialization, product simplicity, and low prices as a way of making the market vastly greater than before.  These were vital pieces of the puzzle, but not quite enough to make a new dominant paradigm.  For one thing, having been hugely dominant in the auto market in 1920, Ford quickly lost market share to General Motors, whose emphasis was on product quality and brand differentiation, and by the 1930s Ford had fallen behind both General Motors and Chrysler.  Clearly the theory was not watertight.

As for ordinary business people, in companies both large and small, they tended to go for high prices and the restriction of competition, whenever they could get away with it.

In short, there was no overall business paradigm that seemed to work for every venture, and certainly no paradigm large and confident enough to fold in public policy-makers and business people in conceptual and practical amity.

Until 1963.

The New Dominant Business Paradigm – Competitive Advantage

I could call it the “Strategy Paradigm” or the “Competitor Paradigm” or the “Competitive Advantage Paradigm”.  I prefer the former (Strategy) but at the heart of it lies a theory of Competitive Advantage between firms, very similar to Ricardo’s theory of Comparative Advantage between nations, but with certain crucial elaborations.

The new theory was developed by Bruce Henderson and colleagues at the Boston Consulting Group.  Practical additions were made by Bill Bain at Bain & Company, by Mitt Romney at Bain Capital, and by Fred Gluck at McKinsey, as well as by other theorists, including Michael Porter, and even in a minor way by me.  The theory did not come together convincingly until around 1970 and has been elaborated ever since.  The big practical shift in behavior by business people started in the 1980s and has been accelerating ever since.

Here is the new paradigm in as simple and short a way as I can manage:

• At the heart of a firm is one or more product-market segments or arenas in which it operates. If the firm operates in several arenas, one of them, or a few, will supply most or all the cash and profit the firm generates (or more than all, if the others are loss-making).  In these few arenas, which are the intersection of the product and a similar group of customers, the firm has competitive advantage.
• There are two principal sources of competitive advantage – being able to supply a decent product at a cost and price lower than that of rival firms, or providing a product which is so useful, easy to use, or aesthetically pleasing that it puts all other firms’ products in the shade.
• Both forms of competitive advantage rely upon having a product that is simpler than that of rivals and produced at greater scale.
• Market share is valuable and should be measured in a specific – often highly specialized – arena, and relative to competition. In terms of relative advantage, it is better to have a forty percent market share with the nearest rival having only twenty percent (that is, being twice the size), than to have sixty percent of a market and your rival having forty percent (that is being only half as big again as the rival).
• The most attractive market positions are “stars” – that is, dominant businesses (several times the size of the nearest rival) in high growth markets.
• Segment (arena) positions without competitive advantage should be sold. No exceptions.
• Having a high market share is both the result and the cause of competitive advantage. A lower market share competitor who invents a product that is simpler and cheaper, or simpler and better, than the existing market leader can displace the leader, but only if the difference in product or price is highly marked.  In general a product must be half the price or ten times as good to replace a market leader.
• Low prices and highly appealing products can increase market size by hundreds or thousands of times. This applies to any product or service.
• Global market or niche dominance is the only secure position long-term.
• No market position, even a monopoly, is ever secure. A new leader with a new product idea and/or technology can replace a leader.  This happens suddenly and with increasing frequency today.  There is no need for anti-trust regulation, which nearly always has greater cost than benefit to consumers.
• The other big recent change is that businesses with strong network effects are much more profitable and have greater benefits to consumers than smaller businesses or those with no network effects. “Network effects” mean that a business that is twice as big in an arena is more than twice as valuable to its owners and users than if it were the same size (co-leader in the arena). The natural equilibrium for a network business is to gain most or all of its market arena.  Examples are Google search, Amazon, Alibaba, the Apple iPhone and iPad in tandem with the App Store), and (for the moment) Facebook.
• Firms are usually best if they operate in few activities and specialize only in activities where they have large competitive advantage. All activities (for example, manufacturing, R&D, logistics, sales, and marketing) which are not the signature strength of the firm should be outsourced to other firms, through a simple contractual arrangement or via a joint venture.

How has the Strategy Paradigm Benefitted the World?

“The precepts of strategy,” says Walter Kiechel, former managing editor of Fortune magazine, “have helped make companies more competitive, alert to their circumstances, and resilient.”

I knew from helping some of the biggest and most successful companies on Wall Street in the 1970s and 1980s how wasteful, bovine, and constipated they had become, how size had eclipsed competitive advantage and service to customers and owners equally. Even then, the smarter heads of bloated enterprises began the process of making them leaner and meaner.  The same process had already started, or happened more quickly, in emergent markets, as Korean, Chinese, Indian and other entrepreneurs seized upon strategy as a means of reversing competitive disadvantage.

As managerial capitalism – the preserve of the lucky, lumbering, and undeserving elite – turned into shareholder-value capitalism, and particularly into entrepreneur-driven capitalism (where it had started many centuries ago), East and West competed to provide better products and services, lower prices, and higher profits simultaneously.  “Without strategy and strategy consultants,” Kiechel concludes, “we could have broad swathes of US industry that look like the automakers – uncompetitive on a global basis.”

In short, the Strategy paradigm worked.  It was coherent, intellectually convincing, and dynamic.  Despite its necessary downsides – its creative destruction and destructive creativity – fiercer capitalism based on strategy and competitive advantage was better capitalism, lifting hundreds of millions out of poverty, and restoring honesty and integrity to the global commercial system.