• 22 Jul 2002
  • Research & Ideas

How Business Strategy Tamed the “Invisible Hand”

Theories of competition and strategic planning are essential ingredients in running a global business. In this excerpt from Business History Review, HBS professor Pankaj Ghemawat outlines their development.
by Pankaj Ghemawat

Until the nineteenth century, the scope for applying (imperfectly) competitive thinking to business situations appeared to be limited: Intense competition had emerged in many lines of business, but individual firms apparently often lacked the potential to have much of an influence on competitive outcomes. Instead, in most lines of business—with the exception of a few commodities in which international trade had developed—firms had an incentive to remain small and to employ as little fixed capital as possible. It was in this era that Adam Smith penned his famous description of market forces as an "invisible hand" that was largely beyond the control of individual firms.

Competitive theory has been advanced at Harvard Business School, shown here under construction.

The scope for strategy as a way to control market forces and shape the competitive environment started to become clearer in the second half of the nineteenth century. In the United States, the building of the railroads after 1850 led to the development of mass markets for the first time. Along with improved access to capital and credit, mass markets encouraged large-scale investment to exploit economies of scale in production and economies of scope in distribution. In some industries, Adam Smith's "invisible hand" was gradually tamed by what the historian Alfred D. Chandler Jr. has termed the "visible hand" of professional managers. By the late nineteenth century, a new type of firm began to emerge, first in the United States and then in Europe: the vertically integrated, multidivisional (or "M-form") corporation that made large investments in manufacturing and marketing and in management hierarchies to coordinate those functions. Over time, the largest M-form companies managed to alter the competitive environment within their industries and even across industry lines.1

The need for a formal approach to corporate strategy was first articulated by top executives of M-form corporations. Alfred Sloan (chief executive of General Motors from 1923 to 1946) devised a strategy that was explicitly based on the perceived strengths and weaknesses of its competitor, Ford.2 In the 1930s, Chester Barnard, a top executive with AT&T, argued that managers should pay especially close attention to "strategic factors," which depend on "personal or organizational action."3

By the 1960s, classroom discussions in the business policy course focused on matching a company's "strengths" and "weaknesses"—its distinctive competence—with the "opportunities" and "threats" (or risks) it faced in the marketplace.
— Pankaj Ghemawat

The organizational challenges involved in World War II were a vital stimulus to strategic thinking. The problem of allocating scarce resources across the entire economy in wartime led to many innovations in management science. New operations-research techniques (e.g., linear programming) were devised, which paved the way for the use of quantitative analysis in formal strategic planning. In 1944, John von Neumann and Oskar Morgenstern published their classic work, The Theory of Games and Economic Behavior. This work essentially solved the problem of zero-sum games (most military ones, from an aggregate perspective) and framed the issues surrounding non-zero-sum games (most business ones). Also, the concept of "learning curves" became an increasingly important tool for planning. The learning curve was first discovered in the military aircraft industry in the 1920s and 1930s, where it was noticed that direct labor costs tended to decrease by a constant percentage as the cumulative quantity of aircraft produced doubled. Learning effects figured prominently in wartime production planning efforts.

World War II also encouraged the mindset of using formal strategic thinking to guide management decisions. Thus, Peter Drucker argued that "management is not just passive, adaptive behavior; it means taking action to make the desired results come to pass." He noted that economic theory had long treated markets as impersonal forces, beyond the control of individual entrepreneurs and organizations. But, in the age of M-form corporations, managing "implies responsibility for attempting to shape the economic environment, for planning, initiating, and carrying through changes in that economic environment, for constantly pushing back the limitations of economic circumstances on the enterprise's freedom of action."4 This insight became the rationale for business strategy—that, by consciously using formal planning, a company could exert some positive control over market forces.

However, these insights on the nature of strategy largely lay fallow for the decade after World War II because wartime destruction led to excess demand, which limited competition as firms rushed to expand capacity. Given the enormous job of rebuilding Europe and much of Asia, it was not until the late 1950s and 1960s that many large multinational corporations were forced to consider global competition as a factor in planning. In addition, the wartime disruption of foreign multinationals enabled U.S. companies to profit from the postwar boom without effective competitors in many industries.

A more direct bridge to the development of strategic concepts for business applications was provided by interservice competition in the U.S. military after World War II. In this period, American military leaders found themselves debating the arrangements that would best protect legitimate competition between military services while maintaining the needed integration of strategic and tactical planning. Many argued that the Army, Navy, Marines, and Air Force would be more efficient if they were unified into a single organization. As the debate raged, Philip Selznick, a sociologist, noted that the Navy Department "emerged as the defender of subtle institutional values and tried many times to formulate the distinctive characteristics of the various services." In essence, the "Navy spokesmen attempted to distinguish between the Army as a 'manpower' organization and the Navy as a finely adjusted system of technical, engineering skills—a 'machine-centered' organization. Faced with what it perceived as a mortal threat, the Navy became highly self-conscious about its distinctive competence."5 The concept of "distinctive competence" had great resonance for strategic management, as we will see next.

Academic Underpinnings

The Second Industrial Revolution witnessed the founding of many elite business schools in the United States, beginning with the Wharton School in 1881. Harvard Business School, founded in 1908, was one of the first to promote the idea that managers should be trained to think strategically and not just to act as functional administrators. Beginning in 1912, Harvard offered a required second-year course in "business policy," which was designed to integrate the knowledge gained in functional areas like accounting, operations, and finance, thereby giving students a broader perspective on the strategic problems faced by corporate executives. A course description from 1917 claimed that "an analysis of any business problem shows not only its relation to other problems in the same group, but also the intimate connection of groups. Few problems in business are purely intra-departmental." It was also stipulated that the policies of each department must maintain a "balance in accord with the underlying policies of the business as a whole."6

In the early 1950s, two professors of business policy at Harvard, George Albert Smith Jr. and C. Roland Christensen, taught students to question whether a firm's strategy matched its competitive environment. In reading cases, students were instructed to ask: Do a company's policies "fit together into a program that effectively meets the requirements of the competitive situation?"7 Students were told to address this problem by asking: "How is the whole industry doing? Is it growing and expanding? Or is it static; or declining?" Then, having "sized up" the competitive environment, the student was to ask: "On what basis must any one company compete with the others in this particular industry? At what kinds of things does it have to be especially competent, in order to compete?"8

In the late 1950s, another Harvard business policy professor, Kenneth Andrews, built on this thinking by arguing that "every business organization, every subunit of organization, and even every individual [ought to] have a clearly defined set of purposes or goals which keeps it moving in a deliberately chosen direction and prevents its drifting in undesired directions" (emphasis added). As shown in the case of Alfred Sloan at General Motors, "the primary function of the general manager, over time, is supervision of the continuous process of determining the nature of the enterprise and setting, revising, and attempting to achieve its goals."9 The motivation for these conclusions was supplied by an industry note and company cases that Andrews prepared on Swiss watchmakers, which uncovered significant differences in performance associated with their respective strategies for competing in that industry.10 This format of combining industry notes with company cases, which had been initiated at Harvard Business School by a professor of manufacturing, John MacLean, became the norm in Harvard's business policy course. In practice, an industry note was often followed by multiple cases on one or several companies with the objective, inter alia, of economizing on students' preparation time.11

By the 1960s, classroom discussions in the business policy course focused on matching a company's "strengths" and "weaknesses"—its distinctive competence—with the "opportunities" and "threats" (or risks) it faced in the marketplace. This framework, which came to be referred to by the acronym SWOT, was a major step forward in bringing explicitly competitive thinking to bear on questions of strategy. Kenneth Andrews put these elements together in a way that became particularly well known. In 1963, a business policy conference was held at Harvard that helped diffuse the SWOT concept in academia and in management practice. Attendance was heavy, and yet the popularity of SWOT—which was still used by many firms, including Wal-Mart, in the 1990s—did not bring closure to the problem of actually defining a firm's distinctive competence. To solve this problem, strategists had to decide which aspects of the firm were "enduring and unchanging over relatively long periods of time" and which were "necessarily more responsive to changes in the marketplace and the pressures of other environmental forces." This distinction was crucial because "the strategic decision is concerned with the long-term development of the enterprise" (emphasis added).12 When strategy choices were analyzed from a long-range perspective, the idea of "distinctive competence" took on added importance because of the risks involved in most long-run investments. Thus, if the opportunities a firm was pursuing appeared "to outrun [its] present distinctive competence," then the strategist had to consider a firm's "willingness to gamble that the latter can be built up to the required level."13

The debate over a firm's "willingness to gamble" its distinctive competence in pursuit of opportunity continued in the 1960s, fueled by a booming stock market and corporate strategies that were heavily geared toward growth and diversification. In a classic 1960 article, "Marketing Myopia," Theodore Levitt was sharply critical of firms that seemed to focus too much on delivering a product, presumably based on its distinctive competence, rather than consciously serving the customer. Levitt thus argued that when companies fail, "it usually means that the product fails to adapt to the constantly changing patterns of consumer needs and tastes, to new and modified marketing institutions and practices, or to product developments in complementary industries."14

However, another leading strategist, Igor Ansoff, argued that Levitt was asking companies to take unnecessary risks by investing in new products that might not fit the firm's distinctive competence. Ansoff argued that a company should first ask whether a new product had a "common thread" with its existing products. He defined the common thread as a firm's "mission" or its commitment to exploit an existing need in the market as a whole.15 Ansoff noted that "sometimes the customer is erroneously identified as the common thread of a firm's business. In reality, a given type of customer will frequently have a range of unrelated product missions or needs."16 Thus, for a firm to maintain its strategic focus, Ansoff suggested certain categories for defining the common thread in its business/corporate strategy. Ansoff and others also focused on translating the logic of the SWOT framework into a series of concrete questions that needed to be answered in the development of strategies.17

In the 1960s, diversification and technological changes increased the complexity of the strategic situations that many companies faced, and intensified their need for more sophisticated measures that could be used to evaluate and compare many different types of businesses. Since business policy groups at Harvard and elsewhere remained strongly wedded to the idea that strategies could only be analyzed on a case-by-case basis in order to account for the unique characteristics of every business, corporations turned elsewhere to satisfy their craving for standardized approaches to strategy making.18 A study by the Stanford Research Institute indicated that a majority of large U.S. companies had set up formal planning departments by 1963.19 Some of these internal efforts were quite elaborate. General Electric (GE) is a bellwether example: It used Harvard faculty extensively in its executive education programs, but it also independently developed an elaborate, computer-based "Profitability Optimization Model" (PROM) in the first half of the 1960s that appeared to explain a significant fraction of the variation in the return on investment afforded by its various businesses.20 Over time, like many other companies, GE also sought the help of private consulting firms.

About the Author

Pankaj Ghemawat is a professor at Harvard Business School.