Sunday, November 30, 2014

The Senators' Sons Problem

Imagine you have to take a test in a room along with 50 other people. I will administer the test, and it will be objective – perhaps just straightforward math problems – and I will grade it anonymously. A very valuable prize goes to each test taker who makes it into the top 5% among the people taking the exam, silently and independently, in the same room with you. You do have a choice, however. You can take the exam in either of two identical rooms, each of which contains the same number of test takers. The only difference between the rooms is the criterion used to select the other test takers. Individuals chosen based on academic merit are in one room. The other room is filled with senators’ sons. Against which group would you prefer to compete?

I have noticed that people prefer to compete against the senators’ sons. Presumably, privileged though they may be, the senators' sons are easier rivals than a group chosen according to their ability. People seem to feel uncomfortable giving this answer in a public setting, perhaps because someone there might be a senator’s son and could take offense (although he may not understand the insult). But keep in mind that we prefer to compete against the senators’ sons not because we think that they all are weak performers. Any one senator's son might be quite sharp. Rather, our intuition is that the privileged group is weaker on average than the average of the merit-based group. This is the senators’ sons problem: Privilege and merit sometimes are negatively correlated. But why?

Behind the senators sons’ problem is a process known as “selection”. In most contests, you have to qualify in order to play – as when people try to get into a school or a company, or when firms vie to get into markets or to do business in different countries. Criteria have to be set up to select who gets into these contests and who does not. When merit is the criterion, those who play must be capable. When some other criterion is used, such as privilege (as in the case of senators’ sons), then for them being capable is optional. And when merit is optional, average levels of merit will be lower.

In life, both merit and privilege together decide who gets to play. If you lack privilege, you better be good. If you lack merit, but are well connected, then you may be able to play too. In situations like this, merit and privilege are negatively correlated: The senators’ sons problem. So if you see someone succeed despite lacking connections, club memberships, and fancy titles, they must be good at what they do. Similarly, if a foreign company excels despite government policies favoring domestic firms, then the foreign firm must be impressive. The same process happens in entrepreneurship, too. Big, established firms rely on their reputation to get business, while start-ups have to prove that they are capable. Consequently, most start-ups fail; those that survive are then especially competitive. In each of these examples, those who make it without privilege had to be good.

I think we all realize that the senators’ sons problem is at work in many areas of life, which is why so many people try to deny their own privileged backgrounds. How we all wish we were a “self-made man." People who claim this are really wanting to say “I’m no senator’s son.” After all, if we got ahead without privilege, then we must be really capable.

So here is the question for you and your organization. How much do you rely on privilege to win in your markets? How much of your performance is based on merit? And, inside your organization, do you reward privilege or merit? In my view, great leaders build companies that win on merit - and inside their firms create systems that reward merit.

For an academic study showing how this idea plays a role in competition, see my paper on compensatory fitness.

Saturday, November 15, 2014

The Red Queen

Do you send your children to the least demanding school you can find? Of course not. What kind of parent are you? You know that they need to measure up to a high standard in school if they are to do well in life.

Yet every day I hear business leaders claim that they want to avoid competition. Are you one of these leaders? What kind of leader are you?

Of course, when organizations compete, they make it difficult for each other to perform well.  But this fact has led to a great misunderstanding. Many business leaders, especially those trained in business schools, infer from this fact that they should avoid competition. That conclusion is wrong.

Pressure from competition causes people to search for ways to improve their company's performance. These improvements, in turn, make companies stronger competitors. So now these improved firms put more pressure on their rivals, who must also find a way to improve. Once those rivals improve, they now are stronger competitors, starting the whole cycle over again. So it is that competition causes organizations to learn, which in turn intensifies competition in a self-accelerating process known as the “Red Queen” effect. This term was coined by the evolutionary theorist Van Valen in reference to Lewis Carroll’s Alice who remarks to the Red Queen: “Well, in our country, you’d generally get to somewhere else – if you ran very fast for a long time as we’ve been doing.” To this the Red Queen responds: “A slow sort of country! Now, here, you see, it takes all the running you can do, to keep in the same place.” Van Valen noted that biological evolution features such change. In my book, I demonstrate that in an ecology of learning organizations, relatively stable performance masks absolute development.

The Red Queen is at work around us all the time, triggering progress on many fronts. When the Korean steel firm Posco came up with the "finex" process, this innovation raised the bar for any firms wanting to compete in the global steel business. Those steel firms that kept pace are still competing today. Similarly, when Qualcomm revolutionized digital wireless transmission by making CDMA technology workable, this put pressure on every other firm in that space to respond. Apple, Samsung, Nokia, Ericsson, LG, and many other firms engaged in that competition for years. Some still are competing, but only by remaining innovative.

The result?  Well, to the firms involved it can feel like they are running in the same place since each is evaluated relative to the others. But for the rest of us, we've seen this:

evolve into this:

As a consumer, you probably think of this amazing record of innovation as something that was inevitable. But this development did not have to happen. Each innovation along the way was carried out by a firm as it attempted to do a better job, in turn raising the bar for others. So perhaps for a while your your device could not map correctly, but by now the problem has been fixed. Competition still thrives in the wireless industry, so each manufacturer keeps pressuring its rivals to do a better job.

Yet according to many, firms are supposed to find a way to avoid competition - to gain "positional advantage" or locate in "blue oceans" where rivalry is weak. Had Qualcomm, Apple, LG, Samsung, and the others taken this advice, how different the wireless industry would be. (Indeed, many experts on the telecommunications industry argued just a few years ago that it was a "natural monopoly", where competition would be "ruinous"!) Avoiding competition would be more comfortable, for sure. But avoiding competition is just a way to shut down the engine that generates innovation.

But, you might say, surely competition is bad for an organization's performance. Don't monopolists outperform other firms? Isn't that why so many companies are trying to dominate their markets? Well, yes, in the short run a monopolist performs better than a firm facing rivalry (other things equal). But over time, that monopolist gets lazy. Meanwhile, over time firms facing competition continue improving. If fact, I estimated the statistical effects of Red Queen competition on hundreds of firms over many, many years, and found the following pattern:

On the left, comparing two inexperienced firms, the monopolist performs better. But over time experience makes the firms facing rivalry improve, eventually becoming better performers than had they found a way to be a monopolist. That is the Red Queen effect. As a firm competes, it becomes more capable, and so performs better. Even though its rivals also perform better, the net effect turns out to be beneficial in time. Highly competitive markets, over time, feature some of the world's most capable and innovative companies.

Reflect on your role as a business leader. Is your job to shield your company from competition? Not if you want it to learn and improve. Short-sighted business leaders hide their companies from competition. Great leaders do just the opposite: They understand that competition teaches. So what kind of leader are you?