Freek Vermeulen considered what is meant by a leader. Leaders are often seen as people with a clear vision of what to do. They can see how events will unfold; they then plan and act accordingly. They direct others to achieve the best outcome. Military analogies often come to mind.
In reality, leaders have to deal with a somewhat hazy and uncertain outlook. They look ahead but they cannot see much. Of course, they have to make decisions, but they have no idea what the world will be like in, say, ten years. Their strategy involves making long term decisions now, not knowing what the long term will be like. Unexpected events will happen, that is clear. The key is being able to respond.
Freek went on to analyse four aspects of leadership: what might be the long-term consequences of action; breaking bad habits; the use of mental models and beliefs; and herding and the uniqueness paradox.
Managers usually understand the short-term consequences of their decisions fairly well but cannot foresee how they will pan out in the long term. Freek illustrated this point with a reference to his work on the UK In-Vitro Fertilisation (IVF) industry.1 UK clinics have to publish their success rate (the percentage of births that result from the treatment). To push up their success rates, many clinics carefully select their patients. By treating only patients with a relatively good ex-ante probability of getting pregnant, they manage to feature higher on the so-called league table.
However, clinics that treat only easy patients may initially have higher success rates, yet they improve very little over time. Clinics that also treat quite a few poor prognosis patients start out with lower success rates, but they improve their performance quite substantially over time. That is because they learn a lot from these difficult patients. After a few years, the clinics that deprived themselves of such learning opportunities by refusing to treat difficult patients ended up with significantly lower success rates than their more inclusive peers (see Figure 1). Put differently: they thought they were being clever but, in the long run, shot themselves in the foot.
Managers often find corporate bad habits difficult to break. Freek gave an example of the UK newspaper industry. Until the early 2000s many were printed as broadsheets. This large format was inconvenient for many readers and more expensive to print than more compact versions. Yet, it was difficult to break the habit of printing in this format.
The practice began as long ago as 1718 when the UK government taxed newspapers according to the number of pages – hence a larger format attracted lower tax. Although the tax was repealed in 1835 the practice continued for many more years.
Mental models of business success influence what you see but also what you miss. Freek referred to Olav Sorensen’s work on film distributors.3 What do they look for in a film when trying to predict whether it will be a success? The number of stars in the film, the experience and prior success of the director and producer are the typical prior beliefs about what contributes to success. These were indeed found to have a good statistical relationship with box office success. Yet, when the marketing budget was also taken into account, the prior belief factors were found no longer to have a significant influence.
Herding behaviour is often criticised but is not irrational. Decision-makers are afraid of being perceived as lone fools. They do not want to miss out on opportunities which others take. An unprofitable decision is not as bad for reputation when others make the same mistake.
However, managers often misjudge the effectiveness of particular strategies and practices. Freek observed this when doing research in the Chinese pharmaceutical industry. Local executives believe that innovators in the industry – those that are engaged in new drug development – outperform the non-innovators. However, on examining their performance, on average the non-innovators significantly outperformed the innovators.
To explain this, Freek measured the variability of firm performance. Innovators had much higher variance than non-innovators (see Figure 5).4 The profitability of the non-innovators, by contrast, was much more evenly distributed. This meant that although the average innovator did worse than the average non-innovator, the few very top-performing firms in the industry were often innovators (despite being worse off on average). Yet, it is the very top performers in an industry that tend to be noticed.
This gives rise to the potential misconception that innovation is a good thing in terms of spurring profitability, while on average that may not be the case.
In combination, these four aspects of leadership can cause managers to seriously misjudge the effectiveness of their strategies. They may not even correct their actions, even when the case for doing so is strong. These behaviours are nothing unusual and extraordinary; they are very common indeed. Paying explicit attention during the decision-making process to thinking through possible long-term effects, potential indirect consequences and differences in variability can help circumvent the problems associated with them.
1 Mihaela Stan and Freek Vermeulen, Selection at the Gate: Difficult Cases, Spillovers, and Organizational Learning, Organizational Science May-June 2013.
2 The title of Freek’s latest book, Breaking Bad Habits: Defy Industry Norms and Reinvigorate Your Business, Ingram Publisher Services, November 2017.
3 Olav Sorenson and David Waguespack, Social Structure and Exchange: Self-confirming Dynamics in Hollywood, Administrative Science Quarterly 2006.
4 Freek Vermeulen and Xu Li Risky business: Analyzing the impact of innovation on firm performance in a changing competitive landscape, ESMT Working Paper.
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