Executive Summary:
Do Management Beliefs or Economics Impact Firm Performance Most?
Basic economic theory expects firms to behave similarly and converge in performance as an industry and competition evolves. But firms do perform differently, and some are successful for long periods of time. Authors David Hoopes, strategy professor from SMU Cox and Douglas Johnson of Purdue developed a simulation from techniques in economics and complexity science that cleverly models interactions between managerial beliefs (cognition) and competitive factors. Their paper “Managerial Cognition, Sunk Costs, and the Evolution of Industry Structure” published in Strategic Management Journal explains when close competitors’ beliefs, strategies, and performance differ. Their work builds on economic and cognitive theories of strategy.
Background
Most competitive strategy research assumes firms behave like rational actors. These economics-based approaches assume that profitability attracts new entrants. Imitation and entry then push down profitability. Industries are perfectly competitive: classic textbook economics. However, if firms are limited in the amount of information they can get from their competitive environment and limited in the amount of information they can effectively use, the results of competition can differ from those predicted by simple versions of economic theory. These limits are called “bounded rationality.” Research from another camp believes that industry structure is developed by the shared beliefs of managers thus defining the industry from a sociologically-based viewpoint.
Hoopes and Johnson’s work means to reconcile these perspectives. “In this research we take issue with the idea that shared beliefs or managerial perceptions determine industry structure separately from economics,” Dr. Hoopes explained. “We believe that perception is important, but in a different way than prior theories. We are concerned with how managers see things differently versus similarly. Further, we think exogenous factors (those out of the control of managers) like potential for economies of scale or sunk costs have a great deal to do with how competition is conducted.” In this paper, theory from economics and other social sciences is bridged to offer new insights into why firms perform differently and accounts for the more complex nature of business strategy and the evolution of industries.
Bounded Rationality and Sunk Costs
As most managers know, the amount of information that can be known and processed is limited, the backbone of the concept of bounded rationality. Firms will have a tendency to develop biased estimates about their competitive environments. In the simulation, bounded rationality (the limits of firms’ information sets) and sunk costs (irretrievable investments- the costs of changing strategies) influence the outcomes of industry structure. These factors were varied over the simulations. While managerial cognition or beliefs do impact results, sunk costs in fact dominate firm results. “Sunk costs, being investments which are irretrievable, are very important in economics and strategy,” Hoopes conveyed. “If firms can change strategies without costs, everyone will figure out the best way to do things or they will agree on a best way. However, if firms are constrained by sunk costs (or having to invest more money) it is more likely that different groups of competitors will agree on local best decisions or local dominant decisions. We then can see clusters of firms with similar strategies. Each cluster differing from the others.”
Implications
The influence of managerial cognition on strategic outcomes is not very well understood. Typically the world of strategy has been viewed from a more rational perspective. How perceptions influence strategic outcomes has not been explored. How actors view things is very important though. Hoopes put forth the example of Bill Gates of Microsoft, AOL’s Steve Case, and Jerry Yang (co-founder of Yahoo); each foresaw different opportunities. Yet they were all constrained by their sunk costs as well. For example, when the Internet browser market heated up in the mid-90s, Microsoft was in the process of getting Windows 95 to the market. That was their sunk cost at the moment. They couldn’t just drop what they were doing and change their strategy. This (with some other important factors) delayed their forays into the Internet for a period. The other actors didn’t have the capital of Microsoft, had different backgrounds and experience, and so staked out different positions. “These differences matter very much in the outcome, and are not integrated very well in strategy research,” Hoopes stated. “These firms made different commitments, and the sunk costs influence the directions they go in the future.”
Sunk costs can be a strong determinant of industry structure in a number of ways. For example, in the auto industry where the industry has converged on different segments in the market; the cost of changing strategy is fairly high due to the cost of plants, workers, and so on. Thus firms often start off in one segment and can only slowly move into another. Thus firms cluster into different segments (although many firms are now developing positions in almost all segments). “Banking is an example where some strategic changes can be costless. When one bank offers money market checking, the others follow suit as the cost to change is not very high,” Hoopes elaborated. “Other banks, in an effort to distinguish themselves, will focus on certain services—Merrill with research and Morgan Stanley with its relationships.”
Often differing managerial beliefs can lead to certain type of investment. Again, sunk costs dominate strategic choices and directions. People can be a sunk cost especially in consulting firms as in the case of McKinsey with its global reach and autonomous consulting offices. With its existing cadre of specialist consultants, changing into other consulting segments could be cost prohibitive. Prior investments matter whether it be a facility, human resources, or other sunk costs.
Fitness Landscapes and the Future
Drawing upon economics, strategy, psychology, artificial intelligence, and complexity science literature, this model helps explain the conflicting evidence from industry-level managerial cognition literature. There appears to be a connection between the models produced in this research and the emerging interest of the organization sciences in complexity theory. In complexity, the concept of fitness landscapes emerged whereby firms try to find an optimal point and move toward the things they should be doing to reach it. “What is more realistic for firms than finding the absolute best position (globally optimal) is to find what is best in their domain and get to that point. Over time the horizon changes once that point is attained. There may however be another new optimal point on the horizon, but getting there will depend on the costs of change,” explained Hoopes.
From the usable simulation developed in this paper, a process of emergent structure at the industry level of analysis is available. “Where you commit yourself in an early stage is important and how you perceive things, but these issues comes up in all stages of an industry’s evolution. In particular, this research is pertinent when there are big changes in an industry which will impact incumbents and new entrants differently,” Hoopes concluded.
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