Strategy and Structure

Yes, I know, Chandler already wrote a famous book about it. But he was talking about something else. He was talking about strategy as structure. Hmm. Come to think about it he was right.

We have discussed the problem of expectations here many times, and it was recently argued that modern economics has a problem because it assumes that expectations are formed in the face of reality. That is to say expectations are consequent to a proper understanding of that reality.

This is wrong.

Expectations are formed as a consequence of an understanding of reality, but also with an understanding that reality is inherently uncertain and thus unknowable. Given this level of uncertainty the resultant expectations are simply ‘hopes’ or ‘wishes’. They do not represent reality accurately, but, rather, they represent hoped-for reality.

In business terms these ‘hoped-for’ realities are called strategic plans. They provide a basis for action because reality, given its uncertainty, provides no basis for action. The uncertainty would prevent concrete action that requires much of timeframe to be taken. A strategy provides an alternative view of reality, one within which actions can be taken with confidence. This confidence is, of course, limited by the degree with which the strategy is assumed to match whatever reality unfolds as it is played out.

So an expectation is, in truth, an educated guess about the future. It does not reflect reality, but is an attempt to shape it.

Add all the expectations together as they are acted upon and an actual reality starts to emerge. In business, for instance, strategic plans might call for a certain amount of investment on the understanding that the returns on that investment via sales of product justify its upfront cost. As the plans start to be acted upon investment takes place and is reflected in the information of a subsequent time period. This then becomes the new reality business needs to take into account as it adjusts its plans.

Thus there is a constant feedback between expectations and the subsequent reality they are expectations of. Indeed, to a large degree, expectations are fulfilled as the reality they aspire to predict. But the relationship between expectation and future reality can never be one-for-one: inaccuracies are inevitable because different people have different attitudes towards exactly the same piece of information, people react differently, they have different understanding of their own goals and intentions that others don’t have, and so on. In other words no expectation will match future reality perfectly unless by dumb luck. Adjustment will always be required. And each adjustment introduces more probability for further error. So expectations and reality are constantly diverging and then being nudged back towards each other as the future is revealed in the present.

The economy is a product of intentions. It is not an accident. Nor is it a product of something like a natural law. It is an intended phenomenon. Even if its actuality is not what was intended. The divergence between the intention and the reality is simply a definition of our inherent incapability of predicting accurately within such a vastly complex system as an economy.

Now there is a great deal of path dependence in all of this. Strategies cannot ignore the past because the past provides the basis of resources, capabilities, and intelligence upon which they are built. So, whilst the future is not predicted by the past, it is certainly influenced by it. This is why many economists have been able to ignore the fundamental issues raised by uncertainty: path dependence creates the illusion that the future is, indeed, predictable from the past. It is also why these economists almost always fail to predict the economy well: they fail to acknowledge that the accumulated difference between intention and actuality may represent a systemic bias in the ay expectations were formed.

This is what happened before the last crisis. Expectations throughout the system rather than offsetting and thus limiting the divergence from actuality as it unfolded, were biased in one way. They thus added to the divergence and did not limit it. Since too many plans assumed a certain and agreeable set of facts, when those ‘facts’ turned out to be errors the accumulated difference was sufficient to cause what some people call a ‘tail’ event: one that occurs only very infrequently and which is thus often assumed to be unpredictable. But such events are predictable, they always lurk within the realm of possibility, albeit in emote parts. The reason we often fail to predict such events is precisely rooted in our failure to understand that expectations are educated guesses that shape future reality rather than being, as some economists would claim, exact representations of that future.

The notion that our economic future is an intentional consequence of our inherently inaccurate guesswork and is thus irrevocably error prone doesn’t sit well in some circles. In business, however, it is taken as fact. Which is why business seeks to influence that future in order to limit the degree of potential error. And it is why business loves structure: structure adds certainty by providing reliable reference points to guide planning.

Which brings me back to our modern economy and its apparent hyperactive and disruptive mode of action. As the plethora of new start-up businesses rise and fade with apparent increasing speed many commentators focus on this relentless Schumpterian creation and destruction. They fail to notice that this acceleration is taking place within the context of a parallel increase in structure which mitigates the destructive consequences of all that so-called creation.

The increase in structure is apparent in the rise of a group of dominant businesses and institutions that have the ability to dictate and thus make predictable much of the ‘playing field’ upon which those start-ups play. They set the technical standards, they provide the infrastructure, they make up the rules, they institute monopolies in some areas, and they create what are called product ecologies in which the minnows can flourish. As the speed of innovation has increased, so too has the formation of these new structures, often having been the product of some recent innovation themselves.

The banking industry, the venture capital suppliers, various technical standard groups, government activity such as changes in the relevant law to protect patents, and so on, are all sources of such structure: they are the institutional framework within which expectations are formed. They all limit the degree with which expectation can diverge from future reality. They thus encourage activity: the less the divergence the higher the degree of confidence in those expectations.

Now we might think that our much discussed access to ever greater amounts of information would move the economy more towards the so-called perfect information world assumed in much of economic theory. But it doesn’t.

This is because in order to survive all business must retain an information advantage over consumers. If information is perfectly available to all then there is not function for business to perform, since the perfection of information implies that transferrence to consumers of a sufficiency in production. Why, then, would they tolerate the intermediate presence of a production process whose space absorbs value that otherwise flow to the consumer?

Economics elides this conundrum by pushing the creative process off to one side, encasing it in a black box, portraying it as a ‘production function’ and pretending that the only relevance of information is that conveyed by price. By so doing economics frees itself to pretend that the perfection of information would only make transacting more efficient, as if transacting were the total sum of all economic activity. It isn’t: creativity and consumption sit on either side of transacting and compete to divvy up the value represented throughout the entire circle encompassing creation through to consumption.

And it is the asymmetry of information in the real economy that allows value to flow through that circle. Businesses actually compete with their customers for information in order to protect their ability to extract value from creation. So perfecting information would stop the economy dead in its tracks. It would not make it more efficient.

Imperfect information ought not just be the rule in economics, it is the reason economies exist in the first place.

Chandler’s whole thesis, from this point of view, was built upon the  realizition of the relationship between strategy and structure. He thus had a better understanding of what expectations actually are than economists who make extravagant claims for them. He also presaged the idea that businesses are simply hoards of information. After all, what is a business structure other than a set of ideas being acted upon? And what are ideas other than information?