Strategy at the edge of chaos

Strategy at the edge of chaos
Eric D. Beinhocker
“Fishbowl” economics once provided the basis of corporate strategy, but no longer. New theories show that markets are “complex adaptive systems.” Can managers be more than blind players in an evolutionary business game?

T

he economist Paul Krugman says that there are three types of economics: up-and-down economics (“stocks were up andunemployment was down today”), airport-bookstore economics (Ten Easy Steps to Avoid Global Depression), and Greek-letter economics. Greek-letter economics is the mathematical variety, practiced in universities and published in academic journals. And it is in serious trouble.

Historically, Greek-letter economics has rewarded mathematical pyrotechnics over fidelity to the real world. The core theoriesthat Greek-letter economics has produced over the last few decades, such as “rational expectations” and “general equilibrium” theory, are mathematically elegant but lacking in empirical validation.
The author thanks Kevin Coyne, Oliver Engert, Dick Foster, Rainer Gawlick, John Hagel, Somu Subramaniam, George Ugras, and the author’s colleagues in the McKinsey Strategy Forum/Strategy TheoryInitiative for their contributions to this article. Mr. Beinhocker also benefited from the writings of, and discussions with, W. Brian Arthur, Larry Blume, Steven Durlauf, David Lane, and Stuart Kauffman of the Santa Fe Institute.

Eric Beinhocker is a principal in McKinsey’s Washington, DC, office. This article was originally published in The McKinsey Quarterly, 1997 Number 1. Copyright © 1997 McKinsey& Company. All rights reserved. This article can be found on our Web site at www.mckinseyquarterly.com/strategy/sted97 .asp.

109

110

S T R AT E G Y I N T H E N E W E C O N O M Y

The dismal state of the dismal science matters to managers, chief operating officers, consultants, and business professors because much of modern management thinking has been built on a foundation ofGreek-letter economics. The bad news is that this foundation is now in serious doubt. But take heart — the good news is that a radically new one is being put in place.

The roots of management thinking
Many of the most successful and widely used strategy tools today—the five-forces framework, cost curves, the structure-conduct-performance (SCP) model, and the concept of sustainable competitiveadvantage, to name a few— owe their origins to ideas developed in the 1950s in a field known as the theory of industrial organization. Industrial organization theory, which is concerned with industry structure and firm performance, is in turn based on microeconomic theory. Modern neoclassical microeconomics was founded by Leon Walras, William Stanley Jevons, and Carl Menger in the 1870s and synthesized intoa coherent theory by Alfred Marshall at the turn of the last century. Seeking to make economics more scientific, Walras, Jevons, and Menger borrowed ideas and mathematical apparatus from the leading science of their day: energy physics. They copied the mathematics equation by equation, translating it metaphorically (and, according to many physicists, incorrectly) into economic concepts.1 In themid-19th century, energy physicists developed a theory of closed equilibrium systems, which provides the core metaphor of Alfred Marshall’s traditional economics and much of today’s management thinking. Consider a ball at the bottom of a bowl. If no energy or mass enters or leaves the bowl— that is, if the system is closed— the ball will sit in equilibrium at its bottom forever. In economic terms,the sides of our bowl represent the structure of a market (for instance, producer costs and consumer preferences), and the gravity that pulls the ball to its lowest energy state represents profitseeking behavior, pulling a firm to its highest-profit state. If we know the economic forces at work, and if firms are rational, we can predict where the ball will come to rest in the bowl—in other words, the...