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| As he considers
running for president, Newt Gingrich recently agreed to start signing fund-raising letters
for Republicans in state and local races—but only if he got the name of anyone who
responded by contributing money. This is what authors Larry Downes and Chunka Mui call a
digital strategy—in this case, a savvy one that recognizes that the person with the
best information generally wins in a world being disrupted by technology. The authors
argue that similar digital strategies are playing out throughout the world of commerce and
will quickly take hold at successful companies across all industries as it becomes clear
that traditional approaches to strategy can't keep pace with a digital world. In this excerpt, the authors provide an example of what they mean by a digital strategy. Then they expand on the ideas of Nobel Prize-winning economist Ronald Coase to show that the forces at work in the world of on-line commerce will cause fundamental changes in the size and nature of most firms. Christopher Brennan wasn't trying to start a revolution. The regional manager for British Petroleum's 1,600 gas stations in Germany, Mr. Brennan was looking for new sources of revenue in a saturated business. Then he got an idea. Gas stations were exempt from rigid German shopping laws that required stores to close by 6 p.m. during the week and by 2 p.m. on Saturday. Convenience stores attached to the stations already sold basic staples and impulse food purchases 24 hours a day. Why not really exploit the regulatory loophole that let these stores operate outside normal hours? Mr. Brennan had heard about the future of electronic shopping. Why wait for the future? Why not invent it now? Working with discretionary marketing funds (and largely on personal time), Mr. Brennan and a small team created the BP multimedia shopping kiosk, a brilliant combination of digital technology and strategic partnerships with name-brand merchants and credit-card companies eager to try a new marketing channel. At the kiosk, consumers use a touch-sensitive screen to view short videos, select merchandise, and get advice on everything from party planning to the latest fashions. All goods ordered at the kiosk can be picked up the next day at the gas station, or in some cases even delivered to the customer's home. German shoppers, assumed to be hostile both to technology and to new services, embraced the kiosk at once. They confounded marketing dogma by purchasing precisely the kind of goods that no one expected anyone would want to buy off a computer screen in a smelly gas station—fruits, vegetables, and even meats. Shoppers began to use the kiosk to replace, rather than supplement, their regular grocery shopping. German consumers, it turned out, were fed up not only with inconvenient shopping hours but with the quality of their shopping experience. Now they could avoid the crowds, the dirty stores, and the generally unhelpful merchants. A month into a pilot deployment in Munich, Mr. Brennan and his team had redesigned the interface several times and increased the number of participating stations. They began making long-term plans to exploit the stations' prime locations as staging and distribution centers, and to deliver the system directly to home computers using public networks. Mr. Brennan and his team were beginning to see that their project had the potential not just to improve gas station revenues but to re-create the very notion of the "station" and the role it played in the consumer's life. Then they did something really radical. They told the folks at BP headquarters what they'd been up to. Is There a Strategy in the House? Mr. Brennan's story is a story of digital strategy. A manager suspends his disbelief, looks around at technologies that might affect his planning, forms a variety of alliances and partnerships, and then executes. He fine-tunes the experiment not in the laboratory but in the marketplace, with the customer as a true partner. The result, at least in this case, may be the worst nightmare not just for BP's competitors but for a wide range of other retailers, wholesalers, and distributors. We have purposefully chosen an example from outside the world of high-technology companies to demonstrate the broad reach and applicability of digital strategy. What could be less digital than a gas station? What industry less vulnerable than oil and gas exploration, refining, and retailing? Who less likely to remake industries than a lone manager in a country that prides itself on adherence to long-established rules of commercial engagement? But hold on a minute. What does the BP kiosk have to do with business strategy? There was no strategy here, just an idea followed by an experiment. Mr. Brennan did no long-term planning or detailed analysis of the industry. BP, like all large organizations, has a formal strategic planning process and a group of highly trained planners working away in Britannic House, its showcase corporate headquarters, in London. Mr. Brennan was only vaguely aware of the planning activities of this group. He certainly wasn't acting on the basis of their recommendations. Perhaps this is your immediate response. A few years ago, it would have been ours. Strategy, after all, is the process that Michael Porter and others have taught us about: careful, analytical, and based on a thorough understanding of current market conditions and leverage points. Strategy is what big companies do from the top down. Strategy takes time to develop, time to execute, time to evaluate. What Mr. Brennan did wasn't strategy, it was just an application, a reordering of relationships. In a word, it was creative. In the new world, that is strategy. Basic Questions Ronald Coase was in his twenties when he made the most important discovery of his life. He had finished his course work in industrial management at the London School of Economics and decided to spend his last year doing field research. Mr. Coase, a socialist, wanted to show that the state could manage the economy more efficiently than the free market. He came to the U.S. to study the growing American phenomenon of the firm, exemplified by Standard Oil, General Motors, and U.S. Steel. Traveling around the country in 1931, at the height of the Great Depression, Mr. Coase was struck by a few basic questions: Why did firms form at all? Why were they the size they were and not larger or smaller? How did entrepreneurs decide which functions to bring inside and which to leave to the open market? It was an eventful trip. By its end, Mr. Coase had begun to question his faith in socialism and government regulation. In the process, he made a discovery of such importance that it was one of two achievements singled out when Mr. Coase won the Nobel Prize for economics more than 50 years later. Ronald Coase had discovered transaction costs. As we'll see, it is this discovery 60 years ago that explains the new economics of cyberspace and the need for digital strategy. First, though, you need to understand how it is that Coasean economics operate in traditional industrial markets. Transaction Costs, or the Unnatural Nature of the Firm Let's take a simple example of transaction costs. Let's say you work for a firm and you run out of paper clips. Almost assuredly, you will get your paper clips not by going out on the open market but by going down the hall to the supplies department. Your company will keep such basic supplies on hand without giving much thought to the cost of carrying such inventory. Your company will keep paper clips on hand even if there is no discount for buying in bulk. The reason? Even if you could get paper clips on your own for the same price, you still have to get them. This means finding stores, learning what they charge, deciding between the closest store and the one with the best price, etc. And that's just for a simple transaction. Imagine instead that you were buying raw materials needed to manufacture your product. There is the additional effort of negotiating a price, writing a contract, inspecting the goods, and, potentially, invoking the legal system to enforce the contract. Better, you say, to own the supplier or at least to buy in bulk and avoid all that trouble. That trouble is transaction costs—a set of inefficiencies in the market that add to the price of a good or service. Transaction costs range from the trivial (turning over the box to see what the price is) to amounts greatly in excess of the transaction itself (imagine if you were seriously injured by a defective paper clip). Mr. Coase thought transaction costs should be studied carefully. He eventually concluded that they are responsible for the creation of firms. The cost of organizing and maintaining firms is lower than the transaction costs involved when individuals conduct business with each other using the market, Mr. Coase decided. What functions should a firm perform internally? Only those that cannot be performed more cheaply in the market or by another firm. In fact, as Mr. Coase says, a firm will tend to expand precisely to the point where the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction through the open market. For some activities—say, plumbing—the open market works relatively well, and the need for plumbers to form large firms to avoid transaction costs has never arisen. For the large-scale operations of General Motors and U.S. Steel, which require coordination, heavy capital investment, and complex distribution systems, the firm is the only viable solution. Viable, but not perfect. As anyone who has ever worked for an organization knows, the cost of performing a function inside a firm is the creation of bureaucracy. Bureaucracy increases as the size and complexity of the firm increase, sometimes causing the internal costs of a business to approach or surpass the alternative transaction costs of the market. We have seen employees using their own travel agents rather than hassling with corporate travel departments, or computing at home where they can avoid the needless oversight of the corporate I/S group. Blown to Bits Even before the digital revolution, technology played a central role in the development of firms. Mr. Coase noted in 1937 the enabling role of communications technologies like the telegraph and telephone, which reduced the cost of maintaining a large-scale organization across wide distances and thus made possible the creation of larger firms. Up until now, the role played by digital technology has been consistent with that history. Computers, networks, and large-scale data storage capabilities have made it possible for bigger and more complicated firms to emerge, casting their shadow over a wider range of activities in an increasingly global market. According to the Bureau of Economic Analysis, U.S. companies spent $212 billion on information technology in 1996 alone, or roughly 5% of gross domestic product. Think of the global financial markets and their dependence on such technology. They couldn't exist without technology, and they didn't. Large-scale industrial companies are also in some sense creations of digital technology. For example, British Petroleum coordinates oil exploration, refining, and retail distribution on a worldwide basis, with major operations in such out-of-the-way spots as Alaska and Vietnam. So it is ironic that the long-standing servant of such firms has now become their worst nightmare. Just as technology reduces the costs of operating a firm, it reduces the costs of the market itself. It's not only firms that get more efficient, in other words; the market is also getting more efficient. Moore's Law (that the cost of a unit of computing power falls 50% every 18 months) and Metcalfe's Law (that the value of a network increases exponentially as people join it) are working to create a new marketplace. Transaction costs in this marketplace are reduced not incrementally (as they are in today's firms with reengineering and similar cost-cutting activities) but exponentially. The resulting economic disruption is twofold: 1. Transaction costs are falling, in many cases dramatically, for nearly all goods and services. 2. They are doing so much faster in the open market than they are for firms. Think of the Internet not as a network of connected computers but as the testbed for a new market economy, one that is global, continuously operating, and increasingly automating the processes of buying, selling, producing, and distributing. To return to the paper clip example, instead of leaving the building, you can now simply point yourself to Office Depot's Web site, click on the product you want, give them your credit card number, and get the paper clips the next day via UPS. Soon, that process will be enhanced by intelligent software agents, such as those being developed by start-up software companies like Firefly, which use sophisticated pattern-matching algorithms to make recommendations based on your past behavior and the behavior of other shoppers in their growing databases. Buying paper clips on the Web today is hardly a frictionless transaction. But it may already be cheaper than engaging your office bureaucracy. That the market itself could become more efficient by reducing transaction costs is not something Mr. Coase has considered, but the result is entirely predictable. If firms expand until their next transaction would be just as cheap if done outside the firm, what happens when the outside world gets cheaper? The natural corollary is that the firm shrinks. If Mr. Coase is right about the relationship between firms and transaction costs, there is this even more shocking implication, which we call the Law of Diminishing Firms: As transaction costs in the open market approach zero, so does the size of the firm. We don't mean to suggest that such a future is imminent or even possible. For most complex transactions, even the most perfect information flow would still leave considerable transaction costs. The nature of the firm will change, however, and indeed it is already changing. The concept of a firm as a physical entity, defined by its permanent employees and fixed assets, is giving way to what some have called a virtual organization, where employees may be part-time or contract workers, where assets may be jointly owned by many organizations, and where the separation between what is inside and what is outside the firm becomes increasingly hazy. Individuals will be participants in many enterprises, like today's entrepreneurs, and those enterprises will be formed around events much closer to transactions than to a sense of corporate immortality. The Law in Operation Today You don't have to look far to see the Law of Diminishing Firms turning the marketplace into the "marketspace." The start-up company Auto-by-Tel, for example, uses the Web to remove many of the expensive and unpleasant transaction costs of buying a car. Visitors to its site review extensive databases to make a selection and are then routed directly to qualified dealers who provide a binding quote within 24 hours. Auto-by-Tel can also provide loans and insurance. The activities of today's car dealer are greatly reduced, and in the end may be eliminated. Even renegade middlemen like Charles Schwab & Co., a leader in the disintermediation of high-price investment firms for small investors, now find themselves threatened by even cheaper technology solutions over the Web (e.g., E*Trade, which operates solely in cyberspace). In the insurance industry, startups like Quickquote are already offering agentless sales for such basic products as term life. Large insurers, meanwhile, are constrained by their more than 650,000 insurance agents in the U.S. alone. The disintermediation of wholesalers, the craze for outsourcing, and even much of the downsizing seen in the last 10 years-each of these is, at its core, a response to decreasing transaction costs in the open market. Just as the Law of Diminishing Firms suggests, the U.S. Department of Labor is already predicting that by 2005 the largest employer in the country will be "self." Outsourcing and downsizing are part of the transition to the new digital economy, in effect replacing monolithic, General Motors-style firms with smaller, more specialized players tied together not by ownership (and bureaucracy) but by communication links. How far will this go? Consider two examples. Mastercard, which processes millions of credit-card transactions a day, has only 1,000 employees, 800 of them in data processing. Sara Lee is selling most of its manufacturing assets, leaving it free to concentrate on managing its brands. 'Just Play' A bus driver from Houston recently test "drove" a prototype stretch of Interstate 15 in San Diego that has been transformed via digital technology into an "autopia," where the road, not the drivers, controls the cars. "I love it," he said. "At first, it was a little scary, but after five minutes you get used to it." Five minutes is about how long you have to react to the disruptions that technology is causing in your markets. You have to do something. By providing a feel for digital strategy, we have suggested what we believe to be the best response available. It is the response, you can rest assured, of your competitors—if not the traditional ones, then certainly those that are rapidly approaching your blind spot. If you follow only one recommendation from this book, follow the one suggested to sociologist Sherry Turkle by a 13-year-old she observed playing SimLife: "Just play." Reprinted by permission of Harvard Business School Press. Excerpt of Unleashing the Killer App:Digital Strategies for Market Dominance by Larry Downes and Chunka Mui. Copyright 1998 by the President and Fellows of Harvard College; All rights reserved. |
