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127. Matt McCaffrey: Austrian Business Strategy (Part 1): Emergent, Not Planned

Strategy is not the formulation of a plan. It is emergent from a process of exploration and discovery. Austrian economics is the best guide for entrepreneurial firms to put in place the methods and organization that unleash the power of emergence. Matt McCaffrey joins Economics For Business for a detailed exposition of the Austrian approach to Business Strategy.

Key Takeaways and Actionable Insights

A firm is a vehicle for entrepreneurial action to generate value.

All businesses and all firms are entrepreneurial. They start from — and continue with — an aspiration to generate value for both customers and the firm, and they act on this intention by assembling assets (resources, people, cash, machines, software, etc.) that are required to realize and deliver value. The goal is to bring a good or service to market that is valued by others. Value is the ultimate goal.

There are clear conditions for this action to take place.

There must be a decision-making authority for the firm, because someone (or some collaborative group) must decide how to select and assemble just the right combination of resources and make a specific product or service from the assembly. We call that decision-making authority the entrepreneur.

A second condition is that someone or some group must bear the uncertainty of the action. It may not turn out the way that was expected. It may not be profitable. Less value may be generated, or none at all. This bearing of uncertainty is also the role of the entrepreneur.

It’s hard to get the operations of the firm just right, because of complexity and change.

Why is all this so hard, and the outcome so uncertain? Two reasons: change and complexity. The subjective valuations of customers, who decide what is more valuable and what is less valuable, are changing and reshuffling continuously, depending on situation, mood, the choices of others, and a myriad of other influences. These changes can become trends, fads, segments, and competitive advantages and disadvantages.

Continuous change contributes to the complexity of the resource assembly puzzle: there are innumerable ways in which resources can be combined and recombined in a firm, and getting the assembly just right is a difficult challenge that is never perfectly resolved.

Therefore, the Austrian view of capital as a flow is a fundamental contribution to rethinking firm strategy.

The resources assembled in an entrepreneurial firm are not valuable in themselves, but because they produce a good or service that the customer values and is willing to pay for. This value — translated into revenue through the customer’s willingness to pay — flows back to the firm as income. The flow of income is affected by each element in the firm’s capital combination and by the degree to which the combination is well-integrated for the value generation task. Customers drive the capital formation task. The entrepreneur is engaged in a never-ending process of combining different capital goods to find the combination that is the most serviceable in generating value. Treating capital as a value-generating flow helps entrepreneurs in practice to manage the persistent process of applying resource combinations in the market to ascertain what value they generate. It’s dynamic process with no pauses.

There are four implications for firm strategy — and they all contrast starkly with the traditional business school view of strategy.

The business school view of strategy takes the form of sophisticated data-fueled top-down planning models. Only a few special minds can take on this intellectually and computationally difficult challenge. Historically, the list of models has included Michael Porter’s Five Forces Model (a model of industry structure and how to create barriers to entry and competition); SWOT analysis (a model of strengths, weaknesses, opportunities and threats from the firm’s point of view, with strategic implications for the management of each element); PESTEL analysis of the business environment (political, economic, social, technological, environmental, legal factors) and how they affect firm performance. The common thread for these models is that they are implemented top-down: the strategists apply the tools, draw conclusions, and instruct the rest of the organization how to act.

Matt McCaffrey’s contrasted this top-down strategy approach to the Austrian strategy approach across four dimensions.

Learning versus Rational Design

The top-down models attempt rationalization: they view strategy as a rational design problem, to shape a distinctive internal competence to seize an external opportunity and evade external threats.

This approach overlooks the crucial problem of learning. In circumstances of uncertainty, unpredictability, complexity and change, learning is the essential method of making progress. Changing conditions can never be known fully enough or fast enough by people at the center (in the strategic planning department) compared to front line employees. Firms must find a way to make use of this front line knowledge, through learning.

Dispersion versus Centralization

To enable the freedom to learn and to apply learning, decision-making must be dispersed through the organization. A single mind or single planning unit can not centralize all the knowledge and can’t centralize decision-making. A strategic plan is not feasible. Organizational design and decision-making processes must be decentralized and dispersed.

Implementation versus Formulation.

A comprehensive plan is impossible. Firms must seek a more adaptive framework. Processes and methods and forms of organization must be capable of adaptation to unforeseen events and new information. Continuous deliberate adjustments must be made in the light of new circumstances, which may arise every day. Therefore, Austrians see strategy as emergent not formulated via a planning process. Adaptive firms implement entrepreneurial actions, and then adapt to the learning, new knowledge and new circumstances that present themselves as a consequence.

Structure versus Strategy

The business school approach is that strategy must be fully formulated, and only then can it be used to shape the structure and processes of an organization. Austrians take the opposite approach: the structure of the firm (its organization, processes, and interfaces with the external environment) shapes strategy. Hayek used the term “structure of production”. This structure can be changed, but not instantly or seamlessly. Structure and strategy influence each other to some extent, but business schools tend to make strategy prior: that a firm is organized in response to the CEO’s vision. Austrians understand that this is not realistic because it’s not possible to restructure an existing organization every time a new vision comes along. There’s a high cost to structural change, and strategy must adjust.

Emergent strategy is based on business rules.

What, then, replaces top-down strategic planning? Austrians use the term “rules”. Rules are an internal device to help managers and employees make decisions on the spot in response to learning and new knowledge. Matt McCaffrey gave an example: whenever there is a break in the supply chain, repurpose old capital goods and bring them into the production process as a low-cost way to fill the gap. It’s a broad and simple rule, and it enables decision-making to go forward at the point of the supply chain break. People close to the action can use their local knowledge to solve the problem within the guideline of the rule.

Another example was given by Bob Luddy, CEO of CaptiveAire, who set the rule for his firm to always have the best price in the marketplace. It’s a simple rule that requires tremendous local knowledge about prices of systems and components, of competitive offerings, and about turnaround time (a cost element of price) among many others. Sales and marketing people as well as engineers can make decisions following this rule.

Rules sustain firm uniqueness.

Business school strategists often focus on competitive advantage as the goal of strategy. But the concept of competitive advantage comes from neoclassical economics and the depiction of markets as bounded cage-fights for market share between similarly-resourced rivals.

Austrian strategy focuses more on firm uniqueness. A firm’s distinctive rules can result in a unique mode of delivering value, and a unique perception in the eyes of customers. A brand is a set of rules that generates such a unique perception.

The ultimate distinction: strategy is exploration.

Strategy is emergent, not planned. Strategy is entrepreneurial. It’s a continuous process of learning through action and discovery. Sometimes, firms discover things they really wish they hadn’t. That’s part of the process through which, eventually, strategy evolves. It’s emergent. Over time, a firm can adopt some simple rules that seem to bring some order, but adaptation to new circumstances is always required. Profit is the signal that adaptation is successful.

We use the term explore and expand to capture the Austrian approach to strategy. Firms are always exploring, seeking ways to improve performance. When some experiments yield promising results, they can be expanded. Explore and expand is a trade-off: how much of the available resources should be allocated to each type of activity. Entrepreneurs manage the trade-off in order to succeed. There’s no strategic plan from on high to make the trade-off for them.

Additional Resources

“Emergent Strategy Process Map” (PDF): Download PDF

Austrian Perspectives on Entrepreneurship, Strategy, and Organization by Nicolai J. Foss, Peter G. Klein, and Matthew McCaffrey: But It On Amazon

“Entrepreneurship and Firm Strategy: Integrating Resources, Capabilities, and Judgment through an Austrian Framework” by Matthew McCaffrey and Ulrich Möller (PDF): Download PDF

“‘When Harry Met Fritz’: Rules as Organizational Frameworks for Emergent Strategy Process” by Nicolai J. Foss, Matthew C. McCaffrey, and Carmen Elena Dorobăț (PDF): Download PDF

Firms Thrive When They Ditch Strategic Planning And Adopt Exploration And Discovery.

Strategic planning enjoys a prestigious image in the business world. It’s taught at the top business schools, and then practiced in an elite corporate department headed by a C-Suite officer. It uses high technology to collect and analyze data, and sophisticated models to determine its recommendations, which ultimately guide the most important business decisions about allocation of capital and resources, which markets to enter and compete in, whom to hire and how to organize, and all the most critical choices a company faces. It is to strategy that winning CEO’s attribute their success, and to which business books and magazines devote their thousands and millions of words.

Strategy is bunkum. At least as it is taught in business schools.

Strategy tries to be objective in a subjective world.

Strategy utilizes data-fueled top-down planning models. Some of the models are mathematical predictions – aiming to forecast how many units will be sold in Pittsburgh or Portsmouth in 2023. Others are frameworks that purport to increase the potential for success. Corporate planning departments pump information into SWOT models, Five Forces Frameworks, PESTEL worksheets and many more data structures with the promise that the analytical outputs will contribute to enhanced business performance by fixing weaknesses, enhancing strengths, cultivating best practices and focusing best efforts. We can classify this thinking as object-based: the business environment is capable of summation in data and simulation in mathematical models and can be shaped and changed by corporate action.

The opposite is the truth. The role of the firm is to generate value for customers, and customers’ evaluations of corporate offerings is subjective. Value is an emotion, an experience of using or consuming a produced good or service and feeling satisfaction. A value-generation process is equally subjective, based on the feeling or intuition or judgement that a business is able to facilitate that experience for the customer. Whilst this value flow is turned into money via the consumer’s willingness to pay for the experience, the revenue flow (which is objective) results from the interaction of business intent to generate value and a customer’s subjective evaluation of whether the business’s value promise was kept.

Learning versus smart design.

How does a business get this interaction with customers right? The B-school peddlers of strategic planning would say, “By design”. They mean data gathering on the external environment, internal assessment of performance and trends and proven capabilities – essentially, looking backwards in order to project forwards.

The Austrian view is that all progress is a function of learning. Specifically, learning about what works and what doesn’t work, without any attempt to forecast the outcome in advance. Which initiatives produce desirable outcomes and which fail to do so. In order to learn, therefore, it is necessary to act, to do something. Do businesses act without knowing what is going to happen as a result? Of course. Are they guided by corporate strategy? Only if the “strategy” is: Let’s learn. Let’s not pre-judge what we think will be the result. Let’s not make false promises to ourselves. And, of course, those sentiments are anathema to the strategists.

Implementation versus Formulation

The consequence of the “Let’s learn” approach to company performance and progress is that strategy can not be formulated from on high, at the top of the organization, and then handed down. The process operates in reverse. The front line of the company, interfacing and interacting with customers, identifies customer needs, makes changes, tries new things, calls for new ideas, experiments and adapts to changing circumstances. There is continuous implementation, doing, responding and observing.

Some of the new ideas and changes become programs or initiatives, and draw resources from elsewhere in the corporation or from partners in a value creation network. Some of these programs hint at success, others don’t. Some become formalized. Some find customers willing to pay, and become revenue streams. They become reinforced with additional resources and the revenue stream accelerates and expands.

This is implementation. There was no strategy formulation preceding the implementation. There probably were some guidelines, some internal signals to channel the external activities – sometimes called corporate culture. There’s a shared sense of generally how the company generates value in response to customer needs and market development. The shared sense is translated into specific implementations by individuals or local offices or customer teams and the learning – the code of “what works and what doesn’t” – is fed back to the corporation for even wider sharing.

Dispersion versus Centralization.

Centralization is a structural attribute of strategic planning. Data is collected and consolidated centrally, and processed centrally. A group of strategists in the administrative center of the organization works with the data to develop plans and allocate resources to those plans.

In the learning-by-implementation method, centralization is damaging. To enable the freedom to learn and to apply learning, decision making must be dispersed through the organization. A single mind or single planning unit can not centralize all the knowledge and can’t centralize decision making. A strategic plan is not feasible. Organizational design and decision-making processes must be decentralized and dispersed.

Structure versus Strategy

In the strategic planning model, a company is structured or organized to take advantage of the strategy that’s been designed for it by the central planners. It’s divided into what are often called strategic business units (i.e. units structured based on the dictates of the designed strategy), and additionally into sub-units, geographies, functions and other pieces. Structure follows strategy. Strategy must be fully formulated before the business can be organized.

Austrian thinking runs in the opposite direction. Austrians take the opposite approach: the structure of the firm (its organization, processes and interfaces with the external environment) shapes strategy. This is particularly important for existing businesses. Too often, strategists (especially if they are external consultants) recommend “transformations”, which require significant structural change. Austrians understand that this is not realistic because it’s not possible to restructure an existing organization every time a new strategic vision comes along. There’s a high cost to structural change, and strategy must adjust.

Strategy is emergent, based on value exploration and new value discoveries.

What, then, replaces top-down strategic planning?

Strategy is emergent, not planned. Strategy is entrepreneurial. It’s a continuous process of learning through action and discovery. Sometimes, firms discover things they really wish they hadn’t. That’s part of the process through which, eventually, strategy evolves. Over time, a firm can adopt some simple guidelines for its frontline members to utilize in their explorations, and these can seem to bring some order. But adaptation to new circumstances is always required. Profit is the signal that adaptation is successful.

We use the term explore and expand to capture the Austrian approach to strategy. Firms are always exploring, seeking ways to improve performance. When some experiments yield promising results, they can be expanded. Explore and expand is a trade-off: how much of the available resources should be allocated to each type of activity. Entrepreneurs manage the trade-off in order to succeed. There’s no strategic plan from on high to make the trade-off for them.