Welcome to Adam Smith's World

For about twenty years, since its launch in the mid 1960s to the late 1980s, IBM's mainframe business - the S/360 family, later renamed S/370 - enjoyed a commanding position in the IT industry.  So successful and profitable was the S/360 that in 1969 the US Justice Department filed an antitrust suit against IBM.  In 1986, for example, IBM was the most profitable company in the Fortune 500, with more than 400,000 employees around the world.

Then everything changed.  Rapid advances in microprocessor technologies in the late 1980s opened the door for new competitors to attack the mainframe with less expensive, client-server, UNIX and PC-based platforms.  We knew what we had to do - transition the mainframes to exploit CMOS microprocessor technologies and introduce IBM's own client-server platforms.  However, these new CMOS-based platforms, along with the software and services around them, commanded significantly lower profit margins than the mainframe margins to which we had become accustomed.

So we had to lower costs and expenses significantly, close factories, lay off people and take a number of additional, very painful actions in order to adapt to the new environment.  By 1994, we had lost almost $16 billion in the previous three years, and our employee population had fallen to 220,000. A plan was initiated that was leading toward breaking up the company into a loose federation of baby blues.  We were very close to ending IBM as a major company.

Welcome to Adam Smith's world.

Adam Smith, an 18th century Scottish philosopher and economist, is generally considered the father of free-market, free-trade capitalism.  The seminal expression of those policies was An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776 and generally regarded as the first work of modern economics.

Smith introduced the famous metaphor of the invisible hand - "the free market, while appearing chaotic and unrestrained, is actually guided to produce the right results by this so-called invisible hand."  It clearly applies to IBM’s situation.  While we survived our near-death experience, most companies do not.  Given enough time, it seems almost inevitable that in highly competitive industries like IT, companies, no matter how powerful their position, will get in trouble in the marketplace when the environment in which they once flourished changes significantly.  They are victims of the invisible hand.  Some will be able to reinvent themselves and overcome their troubles, but more often than not, their problems will prove lethal.

To a greater or lesser extent, every industry in the private sector goes through its own invisible hand struggles when its underlying technologies or markets change.  This is never pretty.  In the struggles to survive, some companies will even slip into the kind of malfeasance that we saw from Enron, WorldCom and other companies when the dot-com bubble burst.   

Short of that, companies and even whole industries often go into a kind of denial, fighting light crazy against the inevitable changes bearing down upon them, instead of working on the innovations that would enable them to adjust.  Some of this has been going on in the media, content and consumer electronic industries, as they transition from analog, proprietary technologies to digital, more open, standard technologies.  As we know, for years, we had very different entertainment and communication devices in the home that did not interact with each other, and could only get content or communicate through their specialized, proprietary networks.  You got TV from cable or satellite; music from radio and CDs; your phone could only be connected to the phone network, and so on. 

An article that appeared around the time of the 2006 Consumer Electronics Show put it very succinctly: "The average American household now owns some 25 consumer electronics products - televisions and stereos and high-tech gimcracks of every imaginable flavor."  It later added: "[The] battleground for things like who makes the biggest flat-screen TV with the highest-definition picture was, of course, in full force at the show. But it is now only one of two battlegrounds. The other - call it branded ubiquity - is about who controls the interaction between the consumer and that gadget and, more and more, all the gadgets in the house as they become interconnected." 

Consumer electronics products are being built using common hardware components from the computer industry (e.g., microprocessors, memory, storage and so on), and most of their capabilities are now being designed as software.  The drive toward open standards to link all the components in the home parallels what has been going on in IT for the last 10-15 years. 

Then there is the emerging role of the Internet for digital media of all sorts.  Media companies are all talking about their vision of the future digital convergence - the epic shift of electronic entertainment, information and communications to the Internet.  The question is not whether digital convergence will happen - that's a given - but which of the many new ideas will take hold in the market, which companies will come out on top, and which will vanish as their business models and profit margins erode and new competitors pick off their customers with less expensive, more convenient offerings.

When industries are going through such epic shifts, a kind of reality gap opens up between those defending their turf and the way things have been, and those who want to shift into the new, emerging environments.  In the late 1980s, we could not believe that our clients did not appreciate the obviously superior quality of our mainframes, compared to the flimsy new PC-based products others were bringing to market.  As it turned out, customers did appreciate the difference.  They left their more critical workloads on the mainframes, but started to put new, less demanding and less mission-critical applications on the much less expensive, good enough  platforms.  The markets were finding their own new balance - as markets are wont to do.  But, in doing so, they do not care one iota about any individual company - just the health of the overall market.  So, some companies flourish, and others decline and perhaps disappear.

A few months ago I participated in a meeting on media and content as part of IBM's 2007 Global Innovation Outlook initiative.  We had executives from various media companies and subject matter experts from academia, as we usually do in GIO meetings.  But in this particular meeting, for the first time, in addition to adult thought leaders we invited younger people - students, some in college, some in graduate school.   As you can imagine, media executives were very concerned with protecting their content, revenues and profit, and the value of their brand as they embrace the new technologies and business models.  But the students - brought up on the Web, instant messaging, social networks and massively multiplayer online games - saw things differently and had little sympathy for the struggles of the media companies.  What the media companies call piracy, the students often referred to as sharing.

Companies whose industries are getting restructured by technological and market forces in front of their eyes - as seems to be happening in just about every industry to a greater or lesser degree - must be flexible and adapt or else face extinction.  This is very, very hard.  Business models drastically change - as happened to us in IBM in the 1980s and is happening to music companies now.  The culture, brand and values of companies get stretched to the limit in such times of crisis. Often, when stretched too far, they break.

If it is your own company fighting to survive, it can be an emotionally painful experience – as I can personally attest.  But, if you can be dispassionate and watch the struggles from afar, it is truly fascinating to see how the invisible hand deals with companies fighting to survive in a rapidly changing marketplace, as they explore how to develop innovative new products and services,  restructure their business models and re-position their brands.  Like spectator sports at their best, the outcome is far from clear.  The unpredictability of free markets is one of the most intriguing aspects of Adam Smith's world.

Comments

[Chris Ward]

OK, here's IBM Lotus Symphony. http://symphony.lotus.com/

No charge, just download it from the web site.

Sharing ? For sure. I don't think Sam P wants a red cent for each copy deployed. Share away to your heart's content, then.

Destructive to markets ? Anticompetitive ? Should IBM be trying to sell it for more than the cost of development and distribution ? Will Microsoft have legitimate cause for complaint, if it trashes the sales of Microsoft Office ? Does IBM worry about the job security of the Lotus Smartsuite service team ? Or rejoice that they can be redeployed now to something more productive.

Not my field. I just do the engineering, the development. I trust Sam P to set the price the way he thinks best.

A good advertisement for IBM Lotus Notes http://www-306.ibm.com/software/lotus/notesanddomino/ , for sure, too.

New millennium. New businesses. Blow hard, that 'wind of creative destruction'.

[Toby Esterhaze]

Let's try to parse this quick and perhaps willfully ignorant review of IBM's history and market power:

"For about twenty years, since its launch in the mid 1960s to the late 1980s, IBM's mainframe business - the S/360 family, later renamed S/370 - enjoyed a commanding position in the IT industry."

Commanding, indeed. In fact, IBM had maintained a huge, 75%-plus share of the data processing market (first in punch card machines and then, electronic computers) for many decades before the S/360 was even a twinkle in Gene Amdahl's eye. IBM had faced three previous government anti-trust suits, the intended effects of which it had skillfully evaded.
What should also be recognized is that IBM's share of the computer industry's total profits held steady at around 90% - completely defying classical economics. In a truly competitive market, theory holds, these high profits would have been eroded and kept in check by rivals selling viable substitute products. That these profits stayed in IBM's hands for as long as they did just shows that IBM enjoyed monopolistic market power. Repeatedly, IBM's own self-evaluations in the 1950s, 60s, and 70s found the company's products technically deficient versus those of competitors.

"So successful and profitable was the S/360 that in 1969 the US Justice Department filed an antitrust suit against IBM."

It wasn't the S/360's success or profits that bothered the government, it was the mechanisms fueling those profits - namely, anti-competitive behavior on IBM's part, including a highly-sophisticated scheme of price discrimination. Look at IBM's own books from the period and you will see that 1) IBM's own analysts found its new machine to be quite lacking and deficient compared to those of Burroughs and Univac and other manufacturers; and 2) to make up for those shortcomings, IBM chose to give away entry-level models of each member of the S/360 to win and retain customers one by one. Unlike rivals, IBM could afford to do this - offering lots of technical support at no charge, for instance - because it had a large reservoir of locked-in customers whom it was charging high-profit prices for earlier generations of gear. Once the new S/360 customer was hooked, IBM charged hefty, high-profit prices for additional memory and peripherals that customers soon needed - and that were not yet available from any other source. Because IBM customers using pre-S/360 gear had to convert their software and retrain their people in the new machine, they were in effect freed to choose from any of the mainframe brands then available. But because IBM's system was actually deficient in comparison, and because IBM wanted direly to maintain its monopoly, the company resorted to giving away its S/360s to make damned sure none of the "Seven Dwarfs" won any new market share.
Later, when plug-compatible sources of add-on gear did become available, IBM had more tricks up its sleeve. It manipulated its mainframes' key interfaces to block competitors and effectively diminish the value of their products. In short, IBM managed to segment its market again and again, charging low where it faced competition (in the market for complete entry-level systems) and high where it faced no competition (where its arbitrary control of interfaces blocked rivals from attaching their peripherals and memory.) When PCM disk drives were gaining ground, IBM moved the profits of its mainframes into the processor - which drew the attention of Amdahl and Japanese makers, who now had new, advanced VLSI technologies in hand.
Again and again (and again), in other words, IBM blocked and evaded and nailed to the table Adam Smith's hallowed invisible hand. The result, of course, was that IBM got fat and lazy, its technologies quite uncompetitive in many ways - and increasingly so, as VLSI took hold and spawned the microprocessor and PC.

"In 1986, for example, IBM was the most profitable company in the Fortune 500, with more than 400,000 employees around the world.
Then everything changed. Rapid advances in microprocessor technologies in the late 1980s opened the door for new competitors to attack the mainframe with less expensive, client-server, UNIX and PC-based platforms."

In fact, less-expensive technologies had been attacking the IBM mainframe business continuously, at least since the first S/360 left the factory floor. The steady advancement of LSI chip technology enabled rivals (and IBM) to produce a steady flow of new mainframes and minicomputers, each providing more computing per dollar than its predecessor. Yet, IBM managed to ward off this threat for two decades and maintain its high profits all the while. How? By bringing out a steady succession of new ever-less-expensive computer lines - System/3, Series/1, System/32, 36, 38, etc. - each of which used its own unique operating system and distinct set of peripherals and interfaces. Again, IBM was segmenting the expanding market, charging new users (who were free to choose vendors) less money per MIPS (to pick just one simplisitic measure) than those who were already locked-in and lacking much choice. IBM might have cloned the S/360 into ever-smaller machines, but that would have encouraged users to adopt those machines for their work instead of paying the (relatively) high prices that IBM charged for its high-end mainframes. Every timesharing app, for instance, was a potential app for a minicomputer, but IBM had to make sure those apps stayed on the S/370 and kept that high-profit business growing.
All the while, IBM's engineers were warning top management of the mess that this market segmentation was creating. It was clear that the future of computing was in networked computers, but with 16 or more distinct hardware architectures and as many operating systems to cope with, IBM was at a huge disadvantage vs. rivals who could offer a single architecture across a wide range of computer models. Hence the roaring success of Digital Equipment and its VAX line - and its DECnet networking scheme, which was hugely more efficient and attractive than the tangled, mainframe-centric SNA networking that IBM and its customers were forced to wrestle with.

"We knew what we had to do - transition the mainframes to exploit CMOS microprocessor technologies and introduce IBM's own client-server platforms. However, these new CMOS-based platforms, along with the software and services around them, commanded significantly lower profit margins than the mainframe margins to which we had become accustomed."

Yes, of course, IBM had to make a huge and difficult transition. But had the company permitted the invisible hand to do its work all along, during all those previous decades, that is, IBM would never have fallen so out of synch with and into such a disadvantage to the rest of its industry. It was quite addicted to those high mainframe profit margins, which were maintained not through tireless innovation in every component and in the face of fierce competition but rather, through exploiting market power - thru changing interfaces willy-nilly and segmenting the market into a hodge-podge of incompatible architectures.

"So we had to lower costs and expenses significantly, close factories, lay off people and take a number of additional, very painful actions in order to adapt to the new environment. By 1994, we had lost almost $16 billion in the previous three years, and our employee population had fallen to 220,000. A plan was initiated that was leading toward breaking up the company into a loose federation of baby blues. We were very close to ending IBM as a major company."

Had IBM been broken up years earlier, as the government and many independent economic observers had called for, this mess might never have happened. A truly competitive computer business, with three or four equally strong, equally viable makers of mainframes duking it out as they slid rapidly down the steepening cost-curve described by Moore's Law. would likely have been much better for customers all along. (And for the American economy, too, but that's another story.) Indeed, without a computer monopoly in existence, it would have been virtually impossible for even as clever an upstart as Bill Gates to establish one in the PC business.

"Welcome to Adam Smith's world."

Better late than never, it seems!

[Jeff Paul Big League Players Club]

Hi, Great post! I felt great reading your blog post. I’m working with my friend in a small internet marketing business as a web developer. When I’m free I go around for some IT info