JANUARY–FEBRUARY 2019 ISSUE

RETHINKING EFFICIENCY
BEGINNING
THE WITH
ELIMINATION ADAM SMITH, BUSINESS THINKERS HAVE STEADFASTLY REGARDED
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The High
by Roger L. Martin
Price of Efficiency
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I
n his landmark 1776 work The Wealth of Nations, Adam Smith showed that a clever
division of labor could make a commercial enterprise vastly more productive than if
each worker took personal charge of constructing a finished product. Four
decades later, in On the Principles of Political Economy and Taxation, David
Ricardo took the argument further with his theory of comparative advantage,
asserting that because it is more efficient for Portuguese workers to make wine
and English workers to make cloth, each group would be better off focusing on its area
of advantage and trading with the other.

These insights both reflected and drove the Industrial Revolution, which was as much
about process innovations that reduced waste and increased productivity as it was
about the application of new technologies. The notions that the way we organize work
can influence productivity more than individual effort can and that specialization
creates commercial advantage underlie the study of management to this day. In that
sense Smith and Ricardo were the precursors of Frederick Winslow Taylor, who
introduced the idea that management could be treated as a science—thus starting a
movement that reached its apogee with W. Edwards Deming, whose Total Quality
Management system was designed to eliminate all waste in the production process.
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Smith,START
Ricardo, Taylor,
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HIGH PRICE together
BREEDSturned management into a science
“THE COSTS OF COMPLEXITY ARE whose
objective function was the elimination
EFFICIENCY
of waste—whether
INEQUALITY
of time, materials, or capital.
HARD TO SEE”

The belief in the unalloyed virtue of efficiency has never dimmed. It is embodied in
multilateral organizations such as the World Trade Organization, aimed at making trade
more efficient. It is ensconced in the Washington Consensus via trade and foreign
direct-investment liberalization, efficient forms of taxation, deregulation, privatization,
transparent capital markets, balanced budgets, and waste-fighting governments. And it
is promoted in the classrooms of every business school on the planet.

Eliminating waste sounds like a reasonable goal. Why would we not want managers to
strive for an ever-more-efficient use of resources? Yet as I will argue, an excessive focus
on efficiency can produce startlingly negative effects, to the extent that superefficient
businesses create the potential for social disorder. This happens because the rewards
arising from efficiency get more and more unequal as that efficiency improves, creating
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a high degree of specialization and conferring an ever-growing market power on the
most-efficient competitors. The resulting business environment is extremely risky, with
high returns going to an increasingly limited number of companies and people—an
outcome that is clearly unsustainable. The remedy, I believe, is for business,
government, and education to focus more strongly on a less immediate source of
competitive advantage: resilience. This may reduce the short-term gains from efficiency
but will produce a more stable and equitable business environment in the long run. I
conclude by describing what a resilience agenda might involve.

To understand why an unrelenting focus on efficiency is so dangerous, we must first

explore our most basic assumptions about how the rewards from economic activities
are distributed.

Outcomes Aren’t Really Random

When predicting economic outcomes—incomes, profits, and so forth—we often assume
that any payoffs at the individual level are random: dictated by chance. Of course, this is
not actually so; payoffs are determined by a host of factors, including the choices we
make. But those factors are so complex that as far as we can tell, economic outcomes
might as well be determined by chance. Randomness is a simplifying assumption that
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fitsPACKAGE
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If economic outcomes are random, statistics tells us that they will follow a Gaussian
EFFICIENCY INEQUALITY HARD TO SEE”

distribution: When plotted on a graph, the vast majority of payoffs will be close to the
average, with fewer and fewer occurring the further we move in either direction. This is
sometimes known as a normal distribution, because many things in our world follow
the pattern, including human traits such as height, weight, and intelligence. It is also
called a bell curve, for its shape. As data points are added, the whole becomes ever more
normally distributed.

Superefficient businesses create the potential

for social disorder.

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Because the Gaussian distribution is so prevalent in human life and in nature, we tend
to expect it across domains. We believe that outcomes are and should be normally
distributed—not just in the physical world but in the world writ large.

For example, we expect the distributions of personal incomes and firm performance
within industries to be roughly Gaussian, and we build our systems and direct our
actions accordingly. The classic way to think about an industry, however defined, is that
it will have a small number of winners, a small number of losers (who are probably
going out of business), and lots of competitors clustered in the middle. In such an
environment, most efficiency gains are swiftly erased as others adopt them, and as
firms fail, new ones replace them. This idealized form of competition is precisely what
antitrust policy seeks to achieve. We don’t want any single firm to grow so big and
powerful that it shifts the distribution out of whack. And if the outcomes do follow a
random distribution, and competitive advantage does not endure for long, competing
on efficiency is sustainable.

But evidence doesn’t justify the assumption of randomness in economic outcomes. In

reality, efficiency gains create an enduring advantage for some players, and the
outcomes follow an entirely different type of distribution—one named for the Italian
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economist
PACKAGE Vilfredo Pareto,who observed more than a century ago that 20% of Italians
ownedSTART
80% of the country’s land. In
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a Pareto distribution,
SUCCESS BREEDS
the vast majority of
“THE COSTS OF COMPLEXITY ARE
incidences are clustered at the lowINEQUALITY
EFFICIENCY end, and the tail at the high
HARD end extends and
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extends. There is no meaningful mean or median; the distribution is not stable. Unlike
what occurs in a Gaussian distribution, additional data points render a Pareto
distribution even more extreme.

That happens because Pareto outcomes, in contrast to Gaussian ones, are not
independent of one another. Consider height—a trait that, as mentioned, tracks a
Gaussian distribution. One person’s shortness does not contribute to another person’s
tallness, so height (within each sex) is normally distributed. Now think about what
happens when someone is deciding whom to follow on Instagram. Typically, he or she
looks at how many followers various users have. People with just a few don’t even get
into the consideration set. Conversely, famous people with lots of followers—for
example, Kim Kardashian, who had 115 million at last count—are immediately attractive
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candidates because they already have lots of followers. The effect—many followers—
becomes the cause of more of the effect: additional followers. Instagram followership,
therefore, tracks a Pareto distribution: A very few people have the lion’s share of
followers, and a large proportion of people have only a few. The median number of
followers is 150 to 200—a tiny fraction of what Kim Kardashian has.

The same applies to wealth. The amount of money in the world at any one moment is
finite. Every dollar you have is a dollar that is not available to anyone else, and your
earning a dollar is not independent of another person’s earning a dollar. Moreover, the
more dollars you have, the easier it is to earn more; as the saying goes, you need money
to make money. As we’re often told, the richest 1% of Americans own almost 40% of the
country’s wealth, while the bottom 90% own just 23%. The richest American is 100
billion times richer than the poorest American; by contrast, the tallest American adult is
less than three times as tall as the shortest—demonstrating again how much wider the
spread of outcomes is in a Pareto distribution.

We find a similar polarization in the geographic distribution of wealth. The rich are
increasingly concentrated in a few places. In 1975, 21% of the richest 5% of Americans
lived in the richest 10 cities. By 2012 the share had increased to 29%. The same holds
for READ 3 PIECES IN THIS
PACKAGE In 1966 the average
incomes.  per capita income in Cedar Rapids, Iowa, was equal to
that inSTART
New York City; now it is 37%
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behind. In 1978 Detroit
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was on a par with New
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York City; now it is 38% behind. San
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INEQUALITY above the national average in
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1980; now it is 88% above. The comparable figures for New York City are 80% and
172%.

Business outcomes also seem to be shifting toward a Pareto distribution. Industry

consolidation is increasingly common in the developed world: In more and more
industries, profits are concentrated in a handful of companies. For instance, 75% of U.S.
industries have become more concentrated in the past 20 years. In 1978 the 100 most
profitable firms earned 48% of the profits of all publicly traded companies combined,
but by 2015 the figure was an incredible 84%. The success stories of the so-called new
economy are in some measure responsible—the dynamics of platform businesses, where
competitive advantages often derive from network effects, quickly convert Gaussian
distributions to Pareto ones, as with Kim Kardashian and Instagram.
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The Growing Power of the Few
Since 1997 a strong majority of industries in the United States have become more
concentrated. Many are now what economists consider “highly concentrated.” This tends to
correlate with low levels of competition, high consumer prices, and high profit margins.

Key: How Concentration Is Calculated

The portion of an industry that is controlled by the top four firms indicates that industry’s
concentration—a measure that changes over time.

Overall, Concentration
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Is Increasing…
Plotting the change in concentrationSUCCESS
of more than 850 U.S.“THE
industries from 1997 to 2012
reveals upslopes in two-thirds of cases
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and downslopes inHARD
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one-third.
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of the downslope chart indicates that nearly all the industries that were highly concentrated
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in 1997 maintained or increased their concentration and that many industries are now very

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highly concentrated indeed.

…Especially When There Are Big Shifts in the Power of the Top Firms
During that time 285 industries (about a third of those studied) were “big movers”—the
market share INofTHIS
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firms changed by at least 10 percentage points. Of those, 216
became
PACKAGE more concentrated and 69 became less so.
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The pattern is even more pronounced among the 92 “very big movers” (for which the market
EFFICIENCY INEQUALITY HARD TO SEE”

share of the top four firms changed by at least 20 percentage points)—and all but 10 of those
industries became more concentrated.

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The Pattern Holds on a Sector Level
Aggregating the data, we see that entire sectors are becoming more concentrated. Here’s
what the four largest look like.
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Let’s examine how the quest for efficiency fits into this dynamic, along with the role of
so-called monocultures and how power and self-interest lead some players to game the
system, with corrosive results.

The Pressure to Consolidate

Complexity scholars, including UCLA’s Bill McKelvey, have identified several factors
that systematically push outcomes toward Pareto distributions. Among them are
pressure on the system in question and ease of connection between its participants.
Think about a sandpile—a favorite illustration of complexity theorists. You can add /
thousands of grains of sand one by one without triggering a collapse; each grain has
virtually no effect. But then one additional grain starts a chain reaction in which the
entire pile collapses; suddenly a single grain has a huge effect. If the sandpile were in a
no-gravity context, however, it wouldn’t collapse. It falls only as gravity pulls that final
grain down, jarring the other grains out of position.

In business outcomes, gravity’s equivalent is efficiency. Consider the U.S. waste-

management industry. At one time there were thousands of little waste-management
companies—garbage collectors—across the country. Each had one to several trucks
serving customers on a particular route. The profitability of those thousands of
companies was fairly normally distributed. Most clustered around the mean, with some
highly efficient and bigger companies earning higher profits, and some weaker ones
earning lower profits.

The 100 most profitable U.S. firms earn 84%

of the profits of all public firms.
Then along came Wayne Huizenga, the founder of Waste Management (WM). Looking
at the cost structure of the business, he saw that two big factors were truck acquisition
(theREAD 3 PIECES
vehicles
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wereIN THIS
expensive, and because they were used intensively, they needed to be
replaced regularly) and maintenance and repair (intensive use made this both critical
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and costly). Each small player bought
EFFICIENCY trucks one or maybe
INEQUALITY HARDaTOhandful
SEE” at a time and ran a
repair depot to service its little fleet.

Huizenga realized that if he acquired a number of routes in a given region, two things
would be possible. First, he would have much greater purchasing leverage with truck
manufacturers and could acquire vehicles more cheaply. Second, he could close
individual maintenance facilities and build a single, far more efficient one. As he
proceeded, the effect—greater efficiency—became the cause of more of the effect.
Huizenga generated the resources to keep buying small garbage companies and
expanding into new territories, which made WM bigger and more efficient still. This
put competitive pressure on all small operators, because WM could come into their
territories and underbid them. Those smaller firms could either lose money or sell to
WM. Huizenga’s success represented a huge increase in pressure on the system.
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Like a collapsing sandpile, the industry quickly consolidated, with WM as the dominant
player, earning the highest profits; fellow consolidator Republic Services as the second-
largest player, earning decent profits; several considerably smaller would-be
consolidators earning few returns; and lots of tiny companies mainly operating at
subsistence levels. The industry today is structured as a Pareto distribution, with WM
as winner-take-most. The company earned more than $14 billion in 2017; Huizenga
died (in March 2018) a multibillionaire.

If WM is so highly efficient, why should we object? Don’t all consumers benefit, and
does it matter whether WM or a collection of small firms issues sanitation workers’
paychecks? The answer is that a superefficient dominant model elevates the risk of
catastrophic failure. To understand why, we’ll turn to an example from agriculture.

The Problem with Monocultures

Almonds were once grown in a number of places in America. But some locations proved
better than others, and as in most production contexts, economies of scale could be had
from consolidation. As it turns out, California’s Central Valley is perfect for almond
growing, and today more than 80% of the world’s almonds are produced there. This is a
classic business example of what biologists call a monoculture: A single factory
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produces
PACKAGEa product, a single  company holds sway in an industry, a single piece of
software dominates all systems. SUCCESS BREEDS
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EFFICIENCY INEQUALITY HARD TO SEE”

Such efficiency comes at a price. The almond industry designed away its redundancies,
or slack, and in the process it lost the insurance that redundancy provides. One extreme
local weather event or one pernicious virus could wipe out most of the world’s
production.

And consolidation has knock-on effects. California’s almond blossoms all need to be
pollinated in the same narrow window of time, because the trees grow in the same soil
and experience the same weather. This necessitates shipping in beehives from all over
America. At the same time, widespread bee epidemics have created concern about the
U.S. population’s ability to pollinate all the plants that need the bees’ work. One theory
about the epidemics is that because hives are being trucked around the country as never
before for such monoculture pollinations, the bees’ resistance has been weakened.
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Power and Self-Interest
As we saw with WM, another result of efficient systems is that the most efficient player
inevitably becomes the most powerful one. Given that people operate substantially out
of self-interest, the more efficient a system becomes, the greater the likelihood that
efficient players will game it—and when that happens, the goal of efficiency ceases to be
the long-term maximization of overall societal value. Instead, efficiency starts to be
construed as that which delivers the greatest immediate value to the dominant player.

You can see this dynamic in the capital markets, where key corporate decision makers
make common cause with the largest shareholders. It goes like this: Institutional
investors support stock-based compensation for senior executives. The executives then
take actions to reduce payroll and cut back on R&D and capital expenditures, all in the
name of efficiency. The immediate savings boost cash flow and consequently cause the
stock price to spike. Those investors—especially actively trading hedge funds—and
executives then sell their holdings to realize short-term gains, almost certainly moving
back in after the resulting decline in price. Their gains come at a cost. The most obvious
losers are employees who are laid off because of the company’s flagging fortunes. But
long-term shareholders also lose, because the company’s future is imperiled. And
customers suffer in terms of product quality, which is threatened as the company
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reduces 
its investment in making
PACKAGE improvements.
START WITH: THE HIGH PRICE OF SUCCESS BREEDS “THE COSTS OF COMPLEXITY ARE
A superefficient dominant model elevates the
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risk of catastrophic failure.

Advocates of shareholder value argue that competition from entrants with superior
products and services will compensate: The newcomers will employ the laid-off
workers, customers will flock to their products, and shareholders will switch to the
investments that promise better returns. But this assumes that the market is highly
dynamic and that power is not concentrated among a handful of players. Those
assumptions are valid in some sectors. The airline industry is one: The main assets—
planes and gates—are relatively easy to acquire and dispose of, so whenever demand
rises, new players can enter. But it is not easy to start a bank, build a chip factory, or
launch a telecom company. (Ironically, entry is perhaps most difficult in some of the
hottest areas of the new economy, where competitive advantage is often tied up with
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network effects that give incumbents a powerful boost.) And sometimes power becomes
so concentrated that political action is needed to loosen the stranglehold of the
dominant players, as in the antitrust movement of the 1890s.

The pension fund business provides a particularly egregious case of abuse by dominant
insiders. In theory, fund managers should compete on the quality of their long-term
investment decisions, because that is what delivers value to pensioners. But 19 of the 25
biggest U.S. pension funds, accounting for more than 50% of the assets of the country’s
75 largest pension funds, are government-created and -regulated monopolies. Their
customers have no choice of provider. If you are a teacher in Texas, the government
mandates that the Teacher Retirement System of Texas—a government agency—
manage your retirement assets. Fund managers’ jobs, therefore, are relatively secure as
long as they don’t screw up in some obvious and public way. They are well placed to
game the system.

The most straightforward way to do so is to accept inducements (typically offered by

hedge funds) to invest in a particular way (one that benefits the hedge funds). In the
past 10 years alone, senior executives of two of America’s largest pension funds
(government monopolies, I might add) were successfully prosecuted for taking
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multimillion-dollar
PACKAGE bribes from hedge funds. We can assume that for each occurrence
we see, many more escape our scrutiny—and
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the bribery“THEisn’t
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always so blatant, of
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course. Pension fund managers alsoINEQUALITY
EFFICIENCY accept luxurious trips
HARDthey couldn’t afford on their
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own, and many have left their positions for lucrative jobs at investment banks or hedge
funds.

A particularly insidious pension-fund practice is lending stock to short-selling hedge

funds (pension funds are the largest such lenders), in return for which the funds’
managers earn relatively modest fees that help them meet their returns goals. The
practice lets hedge funds create volatility in the capital markets, generating
opportunities for traders but compromising the ability of company leaders to manage
for the long term. Pensioners suffer while hedge funds and pension fund managers
benefit.

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 If a system is highly efficient, odds are that
efficient players will game it.
The invisible hand of competition steers self-interested people to maximize value for all
over the long term only in very dynamic markets in which outcomes really are random.
And the process of competition itself works against this as long as it is focused
exclusively on short-term efficiency, which, as we have seen, gives some players an
advantage that often proves quite durable. As those players gain market share, they also
gain market power, which makes it easier for them to gain value for their own interests
by extracting rather than creating it.

How can society prevent the seemingly inevitable process of efficient entropy from
taking hold? We must pay more attention to the less appreciated source of competitive
advantage mentioned earlier: resilience.

Toward Resilience
Resilience is the ability to recover from difficulties—to spring back into shape after a
shock. Think of the difference between being adapted to an existing environment
(which is what efficiency delivers) and being adaptable to changes in the environment.
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Resilient
PACKAGEsystems are typically  characterized by the very features—diversity and
redundancy, or slack—that efficiency
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seeks to destroy. “THE COSTS OF COMPLEXITY ARE
SUCCESS BREEDS
EFFICIENCY INEQUALITY HARD TO SEE”

To curb efficiency creep and foster resilience, organizations can:

Limit scale.
In antitrust policy, the trend since the early 1980s has been to loosen enforcement so as
not to impede efficiency. In fact, in the United States and the European Union,
“increase in efficiency” is considered a legitimate defense of a merger challenged on the
grounds that it would lead to excess concentration—even if the benefits of that
efficiency gain would accrue to just a few powerful players.

We need to reverse that trend. Market domination is not an acceptable outcome, even if
achieved through legitimate means such as organic growth. It isn’t good for the world
to have Facebook use its deep pockets from its core business to fund its Instagram
/
subsidiary to destroy Snapchat. It isn’t good to have Amazon kill all other retailers. It
wasn’t good to have Intel try to quash AMD decades ago by giving computer
manufacturers discounts for not using AMD chips, and it wasn’t good to have
Qualcomm engage in similar behavior in recent years. Our antitrust policy needs to be
much more rigorous to ensure dynamic competition, even if that means lower net
efficiency.

Introduce friction.
In our quest to make our systems more efficient, we have driven out all friction. It is as
if we have tried to create a perfectly clean room, eradicating all the microbes therein.
Things go well until a new microbe enters—wreaking havoc on the now-defenseless
inhabitants.

To avoid such a trap, business and government need to engage in regular

immunotherapy. Rather than design to keep all friction out of the system, we should
inject productive friction at the right times and in the right places to build up the
system’s resilience.

For example, lower barriers to international trade should not be seen as an unalloyed
good.
READAlthough
3 PIECES INDavid
THIS Ricardo clearly identified the efficiency gains from trade, he did
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not anticipate the impact on Pareto outcomes. Policy makers should deploy some trade
barriers to ensure that a few massive
START WITH: THE HIGH PRICE OF
EFFICIENCY firms don’t dominate
SUCCESS BREEDS
INEQUALITY HARDnational markets, even if
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TO SEE”
such domination appears to produce maximum efficiency. Small French baguette
bakers are protected from serious competition by a staggering array of regulations. The
result: Although not cheap, French baguettes are arguably the best in the world. Japan’s
nontariff barriers make it nearly impossible for foreign car manufacturers to penetrate
the market, but that hasn’t stopped Japan from giving rise to some of the most
successful global car companies.

Friction is also needed in the capital markets. The current goal of U.S. regulators is to
maximize liquidity and reduce transaction costs. This has meant that they first allowed
the New York Stock Exchange to acquire numerous other exchanges and then allowed
the NYSE itself to be acquired by the Intercontinental Exchange. A fuller realization of
this goal would increase the pace at which the billionaire hedge-fund owners already at
the far end of the Pareto distribution of wealth trade in fewer but ever bigger markets /
and generate even-more-extreme Pareto outcomes. U.S. regulators should act more like
the EU, which blocked the merger of Europe’s two biggest players, the London Stock
Exchange and the Deutsche Börse. And they should stop placing obstacles in the way of
new players seeking to establish new exchanges, because those obstacles only solidify
the power of consolidated players. In addition, short selling and the volatility it
engenders could be dramatically reduced if the government prohibited public sector
pension funds (such as the California Public Employees’ Retirement System and the
New York State Common Retirement Fund) from lending stock.

Promote patient capital.

Common equity is supposed to be a long-term stake: Once it is given, the company
notionally has the capital forever. In practice, however, anybody can buy that equity on
a stock market without the company’s permission, which means that it can be a short-
term investment. But long-term capital is far more helpful to a company trying to
create and deploy a long-term strategy than short-term capital is. If you give me $100
but say that you can change how it is to be used with 24 hours’ notice, that money isn’t
nearly as valuable to me as if you said I can use it as I want for 10 years. If Warren
Buffett’s desired holding period for stock is, as he jokes, “forever,” while the
quantitative arbitrage hedge fund Renaissance Technologies holds investments only for
milliseconds,
READ 3 PIECESBuffett’s
IN THIS capital is more valuable than that of Renaissance.

PACKAGE

The difference
EFFICIENCY in value to the company
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notwithstanding,“THE
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INEQUALITY theCOSTS
HARD TOtwo
SEE” types of equity
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investments are given exactly the same rights. That’s a mistake; we should base voting
rights on the period for which capital is held. Under that approach, each common share
would give its holder one vote per day of ownership up to 3,650 days, or 10 years. If
you held 100 shares for 10 years, you could vote 365,000 shares. If you sold those
shares, the buyer would get 100 votes on the day of purchase. If the buyer became a
long-term holder, eventually that would rise to 365,000 votes. But if the buyer were an
activist hedge fund like Pershing Square, whose holding period is measured in months,
the interests of long-term investors would swamp its influence on strategy, quite
appropriately. Allocating voting rights in this way would reward long-term
shareholders for providing the most valuable kind of capital. And it would make it
extremely hard for activist hedge funds to take effective control of companies, because
the instant they acquired a share, its rights would be reduced to a single vote.
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Some argue that this would entrench bad management. It would not. Currently,
investors who are unhappy with management can sell their economic ownership of a
share along with one voting right. Under the proposed system, unhappy investors could
still sell their economic ownership of a share along with one voting right. But if a lot of
shareholders were happy with management and yet an activist wanted to make a quick
buck by forcing the company to sell assets, cut R&D investment, or take other actions
that could harm its future, that activist would have a reduced ability to collect the
voting rights to push that agenda.

Create good jobs.

In our pursuit of efficiency, we have come to believe that routine labor is an expense to
be minimized. Companies underinvest in training and skill development, use temporary
and part-time workers, tightly schedule to avoid “excess hours,” and design jobs to
require few skills so that they can be exceedingly low paid. This ignores the fact that
labor is not just a cost; it is a resource that can be productive—and the current way of
managing it drives down that productivity as it reduces the dollar cost.

What if we focused on longer-term productivity? Instead of designing jobs for low-skill,

minimum-wage clock punchers, what if we designed them to be productive and
valuable? In TheIN Good
READ 3 PIECES THIS Jobs Strategy, MIT’s Zeynep Ton describes how some discount
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retailers have doubled down on their employees, seeking more-engaged and more-
knowledgeable
EFFICIENCY workers, better customer
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service, lower“THE
SUCCESS BREEDS
INEQUALITY turnover,
HARD TO SEE” and increased sales
COSTS OF COMPLEXITY ARE

and profits, all leading to further investment. A key but counterintuitive element of the
strategy is to build in slack so that employees have time to serve customers in
unanticipated yet valuable ways.

It’s not just businesses that can benefit from a good jobs strategy. The cheap labor
model is extremely costly to the wider economy. When they cut labor costs, companies
such as Walmart simply transfer expenses traditionally borne by employers to
taxpayers. A recent congressional study evaluated the impact of a single 200-person
Walmart store on the federal budget. It turns out that each employee costs taxpayers
$2,759 annually (in 2018 dollars) for benefits necessitated by the low wages, such as
food and energy subsidies, housing and health care assistance, and federal tax credits.
With 11,000 stores and 2.3 million employees, the company’s much-touted labor
efficiency carries a hefty price tag indeed. /
Teach for resilience.
Management education focuses on the single-minded pursuit of efficiency—and trains
students in analytic techniques that deploy short-term proxies for measuring that
quality. As a result, graduates head into the world to build (inadvertently, I believe)
highly efficient businesses that largely lack resilience.

Management deans, professors, and students would undoubtedly beg to differ. But the
curricula show otherwise. Finance teaches the pursuit of efficient financial structures.
Efficient cost management is the goal of management accounting. Human resources
teaches efficient staffing. Marketing is about the efficient targeting of and selling to
segments. Operations management is about increasing plants’ efficiency. The
overarching goal is the maximization of shareholder value.

Of course, none of these in itself is a bad thing. A corporation should maximize

shareholder value—in the very long term. The problem is that today’s market
capitalization is what defines shareholder value. Similarly, this quarter’s reductions in
labor costs are what define efficiency. And the optimal capital structure for this year’s
operating environment is what defines an efficient deployment of capital. Those are all
short-term ways of assessing long-term outputs.
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If we continue to promote these short-term proxies, managers will seek to maximize
them,START
despite the cost to long-termSUCCESS
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HARDhedge
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“THE COSTS OF COMPLEXITY ARE

control of companies and cause them to act in ways that appear, if judged by short-term
proxies, to be highly efficient. Those funds will be applauded by regulators and
institutional proxy voting advisers, all of whom will continue to think their actions have
nothing to do with the production of more-fragile companies.

For the sake of the future of democratic capitalism, management education must
become a voice for, not against, resilience.

CONCLUSION
In his 1992 work The End of History and the Last Man, Francis Fukuyama argued that
the central theme of modern history is the struggle between despotism and what we
now know as democratic capitalism. The latter certainly has the upper hand. But it’s a
stretch to claim, as Fukuyama did, that it has won the war. Every day we find evidence /
that economic efficiency, which has traditionally underpinned democratic capitalism, is
failing to distribute the concomitant gains. The stark realities of the Pareto distribution
threaten the electorate’s core belief that the combination of democracy and capitalism
can make the lives of a majority of us better over time. Our system is much more
vulnerable and much less fair than we like to think. That needs to change.

Roger L. Martin is the director of the Martin Prosperity Institute and a former dean of
the Rotman School of Management at the University of Toronto. He is a coauthor of Creating
Great Choices: A Leader’s Guide to Integrative Thinking (Harvard Business Review Press,
2017).

Success Breeds Inequality

T
by Jacob Greenspon and Darren Karn
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“THE COSTS OF COMPLEXITY ARE
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he recovery from the Great Depression of the 1930s was characterized by a

degree of social solidarity and a narrowing of the gap between rich and poor.
The recovery from the Great Recession of 2007–2009 has been very
different. In the United States, for example, the gap between the wage
growth of the rich and that of the poor has widened significantly, while the difference
in earnings between the most successful firms and the rest has grown dramatically.

Rich People Are Getting (a Lot) Richer

Since 1971 incomes for the bottom half of the wealth distribution have been stagnant,
and they have grown by only a third for Americans in the 50th to 90th percentiles—but
they have more than doubled for the top 10%.
/
The Wealthiest Firms Are Pulling Away
The gap between top-earning and median firms in the United States has grown
drastically since 1990. The latest data shows that firms at or above the 90th percentile
of earnings haveIN returns
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returns of just 15% for median
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/
Find this and other HBR graphics in our Visual Library 

The Tax System Has Grown Less Progressive

Federal income-tax rates for most Americans increased steadily throughout the 1970s
before falling sharply after the 1981 and 1986 Reagan tax cuts. Taxes paid by the
highest-earning Americans on their final dollars of income have dropped sharply since
1966, while taxes paid by those near the middle of the income distribution have
declined by far less—and in some cases have increased.

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Stocks Have Fully Recovered—but Housing Prices Have Not

The weak recovery of housing prices after the 2008 crash has meant that Americans
whose wealth is based in housing assets have become poorer. The bottom 50% of
Americans lost 16% of their wealth, on average, from 2007 to 2016 (after adjusting for
inflation). But the main stock-market indices were 30% above their 2007 levels by 2016
—a rebound that largely benefited the wealthy.

/
Jacob Greenspon is a researcher at the Martin Prosperity Institute.
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Darren Karn is a senior research associate at the Martin Prosperity Institute.
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“The Costs of Complexity Are Hard to

See”
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/
I
n the lobby of Ford Motor Company’s headquarters, in Dearborn, Michigan, sits a
replica of a Model T. The car—the first to be produced on a moving assembly line,
and available for many years in only one color, black—provides a reminder that
efficiency can propel a company to industry dominance. But upstairs on the 12th
floor, president and CEO Jim Hackett is leading the firm toward a different goal:
what he calls corporate fitness. Hackett, who led the office furniture company Steelcase
through an IPO and championed its shift from selling cubicles to selling collaborative
open workspaces, joined Ford’s board in 2013. He left that post in 2016 to become the
chairman of Ford Smart Mobility. In May of 2017 he was named CEO by executive
chairman Bill Ford. In a recent conversation with HBR senior editor Daniel McGinn,
Hackett—who has worked for many years with the strategy adviser Roger L. Martin
(author of “The High Price of Efficiency,” in this package)—discussed the difference
between efficiency and fitness, how he communicates complex ideas to his workforce,
and the challenge of convincing Wall Street that he is succeeding at moving the
company forward. Edited excerpts follow.

HBR: Automobile manufacturers are obsessed with efficiency. Isn’t Roger Martin’s
argument, that a company can be too efficient, sort of heretical?
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Hackett: There’s always been a meme that goes: “Do you want speed, quality, or low
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cost? START
You can afford only two of theSUCCESS
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HARD TO SEE” of all three. But today
COSTS OF COMPLEXITY ARE

we win or lose on the basis of better system design. A system needs to have efficiency
built in, because if it uses too many resources, it can’t survive. But winning isn’t just
about efficiency.

Is it about what you’ve termed “corporate fitness”? What do you mean by that?
People ask, “Why don’t you just say, ‘Let’s reduce costs’?” But when I say “fitness,” I’m
thinking about what Darwin learned about survival of the fittest—that a species evolves
to be more competitive. Being competitive now is about a lot of factors. How long does
it take an order to be delivered? How many products does a company offer? Do you
have the right or the wrong people? Businesses win by having a combination of the
right people and the right design.

/
Your ideas about how organizations evolve stem from Darwin?
Yes. Years ago a professor gave me a bunch of white papers written by physicists at the
Santa Fe Institute, and I became voraciously interested in them. I began to learn about
complex systems theory, which holds that evolution isn’t just a biological process; it can
apply to social organizations as well. I found myself asking, “If Darwin’s ideas exist in
nature, who am I to say they don’t apply in business? What if they apply everywhere?”

How did you apply them at Steelcase?

I was the CEO at Steelcase for 20 years, so like Darwin with biology, I got to see the
company evolve over time. I found myself in a wave pattern, where I was shrinking the
company during recessions, then growing it, then shrinking it, then growing it. That’s
not healthy. We needed to design the company for all states, by lowering our average
costs. That’s part of what I mean by fitness.

It sounds as though you define fitness

as the ability to deal with a shifting
landscape. So if a marathoner is good
at long races, that’s efficient, but a
decathlete can tackle a variety of
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That’s close. Let me use a different
“THE COSTS OF COMPLEXITY ARE
HARD TO SEE”
analogy. Imagine you and I are racing
up a big mountain. I beat you, but only
by a nanosecond. Imagine I show up the
next year for the race and say to myself,
“I’ve got to do better than I did last
year.” I start off the race, and I’m
winning—my time is better. But the
environment on the mountain has
changed, so I need to perform much
better than last year to win again. That’s
Marvin Shaouni what makes this hard—it’s dynamic.
That’s the Darwinian part. Businesses
typically look at market share, profits,
/
and earnings per share. Those are important things. But it isn’t just our earnings per
share versus those of other auto manufacturers that count. It’s our cycle time versus
Amazon’s, for example. Amazon doesn’t make cars, but it could sell them, or it could
sell auto parts. That’s what happens with disruption. You probably don’t lose to the
standard competitors; it’s the mutation coming at you that matters. You can’t count on
the mountain you’re climbing to stay the same.

Your efforts to make Ford fitter include building your models on fewer platforms
and reducing the number of options and configurations consumers can choose
from. Ford made a big push in that direction during the 1990s. Why didn’t it work?
Complexity creeps in over time. In nature, forest fires actually help forests thrive, by
burning away the underbrush. At Ford we’re right in the middle of that work of
eliminating complexity. We’re getting really great results. My concern is that the
gestation period in the auto industry is longer than in the industry I came from. I don’t
want people to lose confidence; I know these theories work. People say, “We haven’t
seen it yet.” They will. The costs of complexity are hard to see until they’re gone.

You have an affinity for very complex ideas, and you describe them in complicated
ways. As a leader, does that create challenges?
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Unquestionably.
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news is, I’ve been through this before, at Steelcase. My job is
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SUCCESS BREEDS I’m purposely using
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Why say “fitness” instead of “reduce costs”? Because the solution to reducing costs is to
hold your breath. And when you hold your breath but don’t change anything else, the
costs come back. During the Great Recession, Ford brought its breakeven down
significantly. But the costs all came back, because the company didn’t change the
design.

I’m working on the communication part. One way is by delegating some of it. Another
is by boiling down our plan so that people can follow it.

Back in 2012 or 2013, near the end of Alan Mulally’s time as CEO, what could have
been done differently to put Ford in a better position today?

/
I always start by saying the management team in place was really smart. So what did it
miss? In my assessment, it missed that our competitors were all bankrupt when our
strategy emerged. Ford was the stronger, fitter player, which allowed it to avoid
bankruptcy—and on one level, that was an advantage. The negative was that
competitors came out of bankruptcy stronger and fitter. Bankruptcy forced them to
redesign their businesses. What Ford missed was that competitors were getting fitter
while we were on a trajectory we could celebrate, so we didn’t change enough.

Does Ford’s status as a family-controlled company make it easier to pursue large-

scale change?
The Fords are what we call long-arc shareholders. They have been owners since 1903,
and they retain 40% of the general voting power. That tells you they’ve got a deep
commitment. Bill Ford wants to win. He’s proud of Ford’s forward-leaning attributes—
the way the company treats its people, the way it affects the environment. But his eyes
get really big when he drives a Mustang; the vitality of the product matters deeply to
him. We had long talks before I took this job. I told him he had a bunch of people he
could choose from and that I might not be the best guy. I wasn’t selling myself, because
I was being asked to consider the job.
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Why might you not have been
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It relates to something you asked about

START WITH: THE HIGH PRICE OF
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transformation going to be really simple and well understood in the early periods? I told
him it would take a while for the internal organization to get traction. We’re going to
get results, and then Wall Street will follow.

Since becoming CEO, you’ve announced that Ford will stop selling most models of
cars in the United States. How did you conclude you can’t play to win in that
segment?
If you drew an outline around the Model T, you’d have a silhouette. I ask people,
“Where is that silhouette today? Is it still on the market?” No. Over time that silhouette
—the shape of the car—has changed, because the world, the markets, and the size of
people have changed.

/
Sedans mutated because buyer preference turned to larger silhouettes, such as sport
utility vehicles. In the past, automakers were reluctant to stop selling small cars,
because they were afraid that if fuel prices went up, they’d get nailed. Low fuel prices
teach us what people really prefer: They prefer larger silhouettes. But now we have new
forms of propulsion—battery electrics and hybrids. We’re designing vehicles that will
deliver a larger silhouette without a penalty in fuel efficiency.

Roger Martin argues that efficiency increases risk by reducing redundancy and
resiliency. Is Ford less resilient because of its reliance on the F-150 pickup truck,
which is responsible for all the company’s profits?
We’re actually in a really favored place with the F-150, where we play to win. We can
take more risks with it. We have other silhouettes with properties of the F-150 that we
get to exploit. The Super Duty—a pickup with more horsepower and higher torque—
grew faster than the F-150 this year. In meetings we talk about what makes the pickup
truck so fit today. Why is it so popular? It’s because buyers have jobs that have to be
done that the F-150 is very good at. So we ask: Do we really understand its
performance? And how can we support those jobs even better in the future?

“Evolution isn’t just a biological process; it

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Ford, like other carmakers, is investing a lot in autonomous vehicles. When will
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they hit the market?

My optimism about that future is really high. It’s probably just further out than people
realize. There’s a quote that goes something like this: People overestimate the impact of
technology in the short run and underestimate its impact in the long run. That’s
probably true in this area. When those vehicles do arrive, they’ll be a dramatic
disrupter.

Is corporate fitness especially important for a global manufacturer during an era of

political uncertainty and shifts in trade policy?
Trade systems are best for us when they’re in equilibrium. You can design your business
around equilibrium. We don’t want to be in a trade war; that’s a bad idea. We don’t
need certainty—we can deal with the ups and downs of weather or raw materials /
shortages. But it’s hard to prepare for a sudden decision to put a 25% tax on something.

You use the word “teach” more than most other CEOs do. Is that an important part
of the way you lead?
In a job like this, you have high-powered people working for you. They don’t need you
to wind them up every day. So the role I have to play is, rather than tell them what to
do, help them see how wisdom and curiosity can help us design better. I’ve asked
employees to let me play that role and to have patience with it. We’re getting into a
rhythm together.

In your industry there’s a lot of focus on Tesla, which built a product people love
but has struggled to scale up production. What do you make of its challenges?
People sometimes say something isn’t rocket science. I actually have a competitor, Elon
Musk, who is a rocket scientist. I have tremendous respect for him because of the way
he questions the design of the system.

Ford builds a vehicle every four seconds. So there’s something about the fitness of our
system that those who are starting out can’t yet equal. How it all gets choreographed is
a really
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question the fitness of the system has improved because of Tesla’s arrival. Customers
now expect over-the-air updates ofSUCCESS
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software“THE
[because Tesla provides them].
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That will be a table stakes thing in the car business that can be attributed to Musk.

Does Tesla’s presence help you convince employees that they need to look beyond
GM and Toyota and imagine new kinds of competitors?
When a car company gets 400,000 or 500,000 preorders for a vehicle, you have to pay
attention. The humility here is what Darwin taught us: There’s no guarantee for your
future. That doesn’t mean we can’t be optimistic. It just means the design probably
won’t stay the same.

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11 COMMENTS

FERENC KONCZ a year ago

Excellent writing. It should however try to compress its ideas into more concise value statements.
Leadership need to understand that there is an intrinsic conflict between efficiency (to do more with less)
and effectiveness (to have things done faster), that requires to reach a healthy ballance between the two.
Also, the article correctly highlights that the international models of doing business have disconnected
business from social responsibility. It was one thing to "streamline operation" in your own city where those to
be made redundant were your acquaintances, relatives, friends-of-friend and where Leadership had to face
locally the consequences of their decisions - and it is a very different situation in the international space
where Leadership may "streamline operations" without ever having to face directly the consequences of their
decisions.
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