Tracking the growth of India’s middle class

India’s rapid economic growth has set the stage for fundamental change among the country’s consumers. The same energy that has lifted hundreds of millions of Indians out of desperate poverty is creating a massive middle class centered in the cities. India continues its recent growth, average household incomes will triple over the next two decades and it will become the world’s 5th-largest consumer economy by 2025, up from 12th now. Along the way, spending patterns will shift significantly as discretionary purchases capture a majority of consumer spending. India’s potential should make it a high priority for most consumer goods businesses, but to succeed in this complex market they must overcome major challenges.

Private consumption has already played a much larger role in India’s growth than it has in that of other developing countries. In 2005 private spending reached about 17 trillion Indian rupees¹ ($372 billion), accounting for more than 60 percent of India’s GDP, so in this respect the country is closer to developed economies such as Japan and the United States than are China and other fast-growing emerging markets in Asia . Aggregate consumer spending could more than quadruple in coming years, reaching 70 trillion rupees by 2025. Higher private incomes and, to a lesser extent, population growth will encourage this rise in consumption. Changes in savings behavior will play only a minor role.

With such growth on the horizon, it is unclear which companies will win in most product categories. Opportunities will blossom as millions of first-time buyers step up to cash registers and as the bulk of consumer spending moves from scattered, hard-to-reach rural areas to more concentrated, accessible urban markets. Indian consumer spending will shift substantially from the informal economy, with its individual traders, to the more efficient formal economy of organized businesses. That transition will lower prices and further boost demand.

But neither incumbents nor attackers will have an easy time. Bureaucratic hurdles and well-recognized infrastructure shortcomings will frustrate many strategies. In addition, while aggregate spending will rise tremendously, it will be spread across hundreds of millions of households, many with very modest incomes (by the standards of developed countries) and high sensitivity to price and value. Finally, in many consumer markets both Indian and multinational companies already compete intensely for customers. While the opportunities will be enormous, the challenges will force companies to be more dynamic by adapting their products, services, and business models to the rapidly changing needs and incomes of Indian consumers.

Real compound annual growth will be 7.3 percent over the next two decades and that economic-reform efforts will continue. If these conditions are met, the life of the average Indian will change vastly by 2025.

A market rising from poverty

India’s economic reforms, begun in 1991, have substantially improved the country’s well-being, and our analysis shows that further improvements are to come. In 1985 93 percent of the population lived on a household income of less than 90,000 rupees a year, or about a dollar per person per day; by 2005 that proportion had been cut nearly in half, to 54 percent. By our estimate, 431 million fewer Indians live in extreme poverty today than would have if poverty had remained stuck at the 1985 level. We project that if India can achieve 7.3 percent annual growth over the next 20 years, 465 million more people will be spared a life of extreme deprivation

Contrary to popular perceptions, rural India has benefited from this growth: extreme rural poverty has declined from 94 % in 1985 to 61 % in 2005, and we project that it will drop to 26 percent by 2025. While the progress has been substantial—even historic—significant challenges remain. First, there are large regional disparities in growth and in the reduction of poverty: India’s southern and western states prosper, while the northern and eastern states (with the exceptions of the capital region, Haryana, Himachal Pradesh, and Punjab) lag behind. Second, while India has been slowly urbanizing over the past two decades, it remains the least urbanized of the emerging Asian economies. Today only 29 percent of Indians live in cities, compared with 40 percent of the Chinese and 48 percent of Indonesians, and we project that the level of urbanization will increase to only 37 percent by 2025.Finally, while more Indians are completing secondary and higher education, the educational system remains severely strained and the quality of and opportunities for schooling vary widely.

In rural areas life may become less desperate thanks to continued growth and to government investment in infrastructure and development. But it will likely remain a struggle, particularly for subsistence farmers in the north and east and for others with little education. For India’s urbanites, especially educated ones, the future looks promising. Many of these households will make the jump not only out of poverty but also into the new and aspiring middle class.

The birth of a new middle class

The growth that has pulled millions of people out of poverty is also building a huge middle class that will be concentrated in India’s urban areas. While urbanization isn’t proceeding as quickly as it is in other Asian economies, rapid population growth means that in absolute terms the country’s urban population will expand significantly, from 318 million today to 523 million in 2025.

Urban growth will bring several important consequences. First, it will put tremendous pressure on the urban infrastructure, which is already heavily overburdened. In India—unlike China, where urban growth is spread across a large number of cities—the economy will continue to be dominated by the megacities (Delhi and Mumbai) plus the six next-largest urban agglomerations. Nevertheless, a handful of smaller places, such as Chandigarh and Ludhiana, will have per capita incomes rivaling those of the major cities and emerge as attractive markets. The shift in spending power from the countryside to the cities will place the bulk of India’s private consumption within easier reach of major companies. Today 57 percent of private spending is spread across rural areas, but by 2025 cities will command 62 percent of the country’s spending power.

Along with the shift from rural to urban consumption, India will witness the rapid growth of its middle class—households with disposable incomes from 200,000 to 1,000,000 rupees a year. That class now comprises about 50 million people, roughly 5 percent of the population. By 2025 a continuing rise in personal incomes will spur a tenfold increase, enlarging the middle class to about 583 million people, or 41 percent of the population. In 20 years the shape of the income pyramid will have become almost unrecognizable .

The Indian middle class has already begun to evolve, and by 2025 it will dominate the cities. By then about three-quarters of India’s urbanites will be part of the middle class, compared with just more than one-tenth today. The expansion will come in two phases, with the lower middle class peaking around 2020, just as the growth of the upper middle class accelerates . About 400 million Indian city dwellers—a group nearly 100 million people larger than the current population of the United States—will belong to households with a comfortable standard of living. For many companies, the sheer scale of this new urban middle class will ensure that it receives significant attention.

What’s more, companies shouldn’t underestimate the market presented by the country’s most affluent consumers: those earning more than 1,000,000 rupees a year—$21,890 in real 2000 dollar terms, or $117,650 in terms of purchasing power parity (PPP). They will remain a small portion of society: about 2 percent of the population in 2025, up from 0.2 percent today. But in absolute numbers, by 2025 India’s wealthiest citizens will total 24 million, more than the current population of Australia. By that year too, India’s affluent class will be larger than China’s comparable segment, projected at about 19 million people. Affluent India’s share of national private consumption will increase from 7 percent today to 20 percent in 2025, which helps to explain the recent rush into the Indian market of luxury goods such as Louis Vuitton bags and Jimmy Choo shoes.

These “global” Indians live mostly in the eight largest cities, so they are very accessible to large domestic and multinational companies. Further, they have tastes similar to those of their counterparts in developed countries: brand name goods, vacations abroad, the latest consumer electronics, and high-end cars.

Changes in consumption

As Indians continue to climb the economic ladder, the composition of their spending will change considerably. In a pattern witnessed in many other developing countries, discretionary expenditures, such as mobile phones and personal-care products, will take up more room in the nation’s shopping basket.

This shift from necessities, defined in our analysis as food and clothing, is already under way—and taking place at lower income levels than we have seen in other countries . We expect that discretionary spending in India will rise from 52 percent of total private spending today to 70 percent in 2025. South Korea went through a similar transformation in the 1980s, when its per capita income levels were about twice those of India now.

Food (including beverages and tobacco) will post the sharpest decline in relative consumption, even as overall spending in the category rises. The fall in the share of food expenditures during our forecast period—to 25 percent, from 42 percent—is linked closely to the growth of the middle class. Despite this relative decline, food will remain the single largest category of expenditure, and we expect that growth in consumption will accelerate to 4.5 percent annually, from 3 percent over the past 20 years.

That growth, however, will appear tepid compared with the rise of other categories. In particular, spending on purchases that improve the economic prospects and quality of life of a person or family—health, education, transport, and communications—will soar and eventually command a greater share of consumption than they do elsewhere. The inadequacy of India’s public-health system, for example, means that private health care is a high priority for many Indian families when their incomes grow. This imperative will drive growth in private health care spending by almost 11 percent a year, so that it will account for 13 percent of the purchases of Indian households by 2025, a larger share than current levels in all of the countries we examined except the United States.

In another remarkable shift, spending on education will grow by 11 percent over the next 20 years, to 9 percent of household consumption, higher than today’s levels in any of our benchmark countries. In rural areas, households emerging from poverty will make educating their children a priority, while higher-income urbanites will be spending more on better-quality education, university degrees, and study-abroad programs. Meanwhile, despite India’s fondness for cricket and “Bollywood” movies, recreational products and services will take a smaller slice of household spending there than in other countries.

Transportation, already the largest category of expense after food, will take a bigger portion of household budgets in coming years, exceeding its share in all of our benchmark countries. The highest growth will come from car purchases. Categories such as clothing and household goods are expected to post slower annual growth relative to overall consumption—6.4 percent and 6.9 percent, respectively—and thus to lose share of wallet. Yet even in these categories, growth rates will remain highly attractive as compared with those in other markets around the world.

What it means for businesses

Three-quarters of India’s consumer market in 2025 doesn’t exist today—about 52.6 trillion rupees a year in future purchases will be up for grabs. Also, India’s rapid upward mobility means that many of India’s households will be new consumers, enjoying significant discretionary consumption in the organized economy for the first time in their lives. Incumbents and challengers alike face a sea change. India’s incumbents, mostly domestic companies, will start with many advantages: existing relationships with customers, an understanding of their needs, and recognized brands.

The incumbents also have established distribution channels—very important in a country of vast geography and limited infrastructure.

But growing incomes and consumption will pressure incumbents from two directions. First, such companies must adjust to the pace and magnitude of change, for as consumers rise through the income brackets, their needs, tastes, aspirations, and brand loyalties will evolve along with their lifestyles. Second, India’s growing consumption will attract a raft of challengers, and ongoing economic reform will significantly intensify competition in many markets. New competition will come from multinationals entering the Indian market, from established Indian companies looking for expansion opportunities, and from entrepreneurs. Indeed, if the country’s policy makers create the conditions for India’s entrepreneurs to succeed, major new companies could be built on the back of consumer growth.

Many incumbents haven’t prepared enough for this discontinuity. They will have to develop a deep understanding of how the consumer’s needs and aspirations will change as incomes grow and find ways of creating innovative products that meet those changing needs. In addition, they must think about how they should introduce new consumers to their products, whether their brands are appropriate for those consumers, and what prices and cost positions will help them compete most effectively for a share of this new middle-class market. Nor is that all: incumbents will have to keep a wary eye on the actions of their current competitors and on new market entrants. That’s a full agenda, and companies that begin preparing today will be in the best position to benefit from the changes.

For attackers, the challenge will be to spot the gaps and opportunities that arise as India’s income and class structure change; they might, for example, ask themselves where small markets or limited competition, or both, have served middle-class consumers poorly. Attackers could also turn to other emerging economies to seek lessons on how tastes and needs will likely evolve in India, perhaps looking in particular for categories in which spending shifted from local products and brands to international ones as aspirations rose. Attackers seeking to exploit these changes should consider what new needs will be unique to Indian tastes and the market as the middle class grows.

In India, as in many emerging markets, multinational companies will find themselves squeezed between the desire of the country’s consumers for a modern middle-class lifestyle and the realities of their limited budgets. In 2005 the average middle-class family spent just over 300,000 rupees annually—roughly $6,600—a very modest sum in real terms, but in PPP terms equal to around $35,000. As one multinational executive noted, however, “You can’t put PPP dollars in the bank, only real dollars.” Multinationals must innovate to deliver an aspirational middle-class lifestyle to families on an Indian budget. Companies that can develop new business models, design products with carefully targeted features, and create brands that appeal to India’s upwardly mobile people will attract huge numbers of eager consumers.

In India, Will Corruption Slow Growth or Will Growth Slow Corruption?

Now that India is playing an ever larger role in the world economy, the issue of corruption, in both the private and public sectors, is coming into sharper focus. Two scenarios are possible: As India's multinational corporations develop both economic and political muscle, they may act as a broom, sweeping corruption from the economic sphere. On the other hand, entrenched practices may prove the stronger force, and corruption could end up being a significant brake on India's economic rise.

The License Raj and the Spoils System

One strand in the knot of corruption is the legacy of the License Raj, which ended in the early 1990s. The system created bureaucracies that were all but self-perpetuating. In a context where government workers were routinely underpaid, graft became an industry all its own. Civil servants were, and remain, anything but disinterested administrators.

"In the bad old days," Singh said in an interview, "particularly pre-1991, when the License Raj held sway, and by design, all kinds of free market mechanisms were hobbled or stymied, and corruption emerged almost as an illegitimate price mechanism, a shadowy quasi-market, such that scarce resources could still be allocated within the economy, and decisions could get made. Of course, this does not in any way condone the occurrence of such corruption. The shameful part of all this was that while value was captured by some people at the expense of others, it did not go to those who created the value, as it should in a fair and equitable system."

The real failing, he said, "was a distortion of incentives within the economy, such that people began expending efforts toward fundamentally unproductive behaviors because they saw that such behaviors could lead to short-term gains. Thus, cultivating those in positions of power who could bestow favors became more important than coming up with an innovative product design. The latter was not as important, anyway, because most markets were closed to foreign competition -- automobiles, for example -- and if you had a product, no matter how uncompetitive compared to global peers', it would sell. These were largely distortions created by the politico-economic regime. While a sea change has occurred in the years following 1991, some of the distorted cultural norms that took hold during the earlier period are slowly being repaired by the sheer forces of competition. The process will be long and slow, however. It will not change overnight."

The costs of corruption are manifest in various parts of the economy. Inadequate infrastructure, of course, is widely recognized as a serious impediment to India's advancement. Producing valuable goods is of limited utility if they cannot be transported in a timely fashion, for example. Transparency International estimates that Indian truckers pay something in the neighborhood of $5 billion annually in bribes to keep freight flowing. "Corruption is a large tax on Indian growth," Ramamurti said in an interview after the conference. "It delays execution, raises costs and destroys the moral fiber."

Corruption also cripples the effort to ameliorate poverty in India and to improve the country's stock of "human capital." The rate at which this happens varies tremendously from region to region. Edward Luce, for example, author of In Spite of the Gods: The Strange Rise of Modern India, notes that "Rates of theft vary widely from state to state in India, with the better states, such as Kerala and Tamil Nadu, getting more than 80% of subsidized government food to their poor. Meanwhile, in the northern state of Bihar, India's second poorest with a population of 75 million, more than 80% of the food is stolen."

Indian MNC's as Change Agents

"A few Indian companies," Ramamurti said, "such as the Tata group or Wipro, have taken the high road, but most firms find it impossible to get anything done without greasing palms." Wipro, headed by Azim Premji, is India's third-biggest global tech services provider (behind Tata Consultancy Services and Infosys). In Bangalore Tiger: How Indian Tech Upstart Wipro Is Rewriting the Rules of Global Competition, business journalist Steve Hamm writes that "Wipro is not just a company, it's a quest." That quest, according to some observers, is as much about moral rectitude as it is about business success. For example, according to Hamm, the company pays no bribes and has a zero tolerance policy for corruption.

"The paradox," Ramamurti said, "is that even though India's faster growth in recent years is the result of fewer government controls, most Indian managers would tell you that corruption has increased, not decreased, in tandem. How could this be? The explanation is that faster growth has created new choke points at which politicians and bureaucrats can extract payments, such as land regulation, spectrum allocation or college admissions -- all of which have become much more valuable in [this century]. Faster growth has also raised the economic cost to firms of delays in public approvals, giving officials that much more 'hold-up' leverage over private investors."

The Benefits of an Open Society

One of the inevitable comparisons in any story on rapidly developing economies is that between India and China. China has endured a spate of bad news in recent months regarding the impact of corruption and shoddy oversight on the quality of exported products -- from cold medication that killed dozens of people in Latin America to toxic toothpaste to children's toys coated in lead-based paint.

If China's initial response was to attempt to characterize much of this as a Western conspiracy against Chinese products and businesses, officials were rather quickly goaded into taking serious action. In July, the government executed Zheng Xiaoyu, who headed China's State Food and Drug Administration from 1997 to 2006.

"The good news in India, compared to China," said Ramamurti, "may be that at least the most egregious forms of corruption are exposed by social activists or the media." A more open society, by definition, provides more avenues for oversight, more empowered constituencies to ferret out and disseminate the truth when things go wrong.

"One big difference," Singh added, "comes in the form of the legal system. In India, a firm can sue the government and win, which may not be as easy in China. Also, the public at large is much more vocal and active in India. Any group can file a Public Interest Litigation (PIL) against a firm, which will frequently get heard in court. Also, it is the case that corporate governance is stronger in India, on average, due to better disclosure and Securities and Exchange Board of India regulatory guidelines. This [is true] even though there are some fine Chinese firms, and some quite poorly governed Indian firms."

Singh ticked off a quick list of additional cultural factors that are to India's advantage: "A fierce -- arguably sometimes to the point of being irresponsible -- media, both the press and TV; a legal system descended from British Common Law like the U.S. which, while hardly perfect, does work reasonably well; [the existence of] certain rights ... such as freedom of speech; strong links with the global economy through, though not solely due to, the non-resident Indian (NRI) community which provides global exposure; and a facility with English which makes for easier integration into the global economy."

As in other countries, however, there is the nagging problem of money corrupting the electoral process and thereby short circuiting, or at least slowing, reform. "The business community and the public at large would welcome a reduction in corruption," Ramamurti said, "but neither believes this will come to pass. Corruption is endemic in daily life, from things minor to major, and it has become the primary means of funding election campaigns."

"The really serious problem here," Singh stated, "is that the prevalence of corruption in the Indian economy may well have distorted cultural norms within the society. Yet I am also aware of countervailing forces, so I do not want to overstate the case. But to the extent that change in cultural norms will be needed to root out corruption, it will take a persistent, long, drawn-out effort. While economic change is easier to achieve, cultural change is much slower and more difficult. This is compounded by the rearguard actions of those who are beneficiaries of the status quo."

Some Improvement; Some Distance Yet to Go

Transparency International monitors corruption globally and puts out an annual report which it refers to as the Global Corruption Barometer. The most recent figures from 2006 provide an interesting perspective on how Indians see progress in the area of corruption.

"Indians report a substantial reduction in the perceived level of corruption in a number of sectors," according to the most recent report. "Improvements encompass education, the legal system/judiciary, media, parliament/legislature and utilities. It should be noted, however, that Indian respondents still indicate that the majority of sectors highlighted are significantly affected by corruption. These improvements should therefore be understood as a positive sign of progress, but not an indication that the problem of corruption has been solved."

How much is left to be done? Some three out of four Indian respondents, on the question of the degree to which their government is fighting corruption, answered that the government was either "not effective," "does not fight at all," or "actually encourages" corruption.

Where does business fit into this? Asked to rate the impact of corruption on various spheres of their lives -- on a scale of one to four, from "not at all" to "to a large extent" -- Indians identified

"Political life" as the sphere most significantly impacted - 2.9

"Personal and Family" life as the least impacted - 2.3

"Business environment" squarely in the middle - 2.6

What institutions are respected? Rating the impact of corruption on different sectors and institutions (on a scale of one to five, from "not at all corrupt" to "extremely corrupt")

Most corrupt institutions

Political Parties- 4.2
Police - 4.3
Business - 3.2

The least corrupt institution - The military, at 1.9

Choose Tommorow's Leaders Today

Succession planning, like any business acumen, is both an art and a science. That is to say, there are many proven strategies that can and must be followed so that successful transition can occur.

Too often organizations address the succession challenge through the rearview mirror. They wait for someone to step down or even worse, be removed. Then and only then do they entertain thoughts of who or what should happen next?

One of the reasons little forethought is given to succession is evident in the fact that it rarely shows up in corporate business plans. Companies are quite diligent in forecasting-out 3, 5 and even 10-years but most of what they plan has more to do with finance, P&L, product evolution and little or no emphasis on who or how future leaders will captain the corporate ship.

It's no secret senior executives, especially those new to the position, see themselves as bulletproof. In their minds, talk of succession is analogous to talk about potential failure - they will be there forever - so they have little appetite for negativities like that preferring rather to concentrate on positive things like how they will make the company successful - perhaps in perpetuity?

Professional consultants like Pat Micallef, VP of international consulting firm The Meta Group, takes a strong position when he says, "The success of any corporate succession, is predicated on the strength of the company business plan, and, it goes without saying," he says, "leadership change is integral to future corporate strategies and should be built-in. The success of which, however, [succession planning] hinges expressly on whether or not the architects of the plan have a clear understanding of three important criteria:

a) What will it take to keep the company running and profitable?

b) What will it take to Grow the company? and,

c) What will it take to Change the company?"

It is here we begin so see more clearly that succession planning is an integral part of a much larger stratagem, more complex, perhaps, than seen at first blush.

Senior executives rise to the top based mostly on their unique and proven skills tacitly believed by corporate board members or company owners to be the stuff necessary to champion the needs of the corporation. In a perfect world, the corporate cream rises to the top in a comfortable and timely fashion - but we don't live in a perfect word - in fact, one could argue we live in a more imperfect world than we'd like to believe.

With that in mind, companies and industries the world over, are addressing the reality that a decade from now, their entire business landscape will be completely different!

Company architects or should be ocused more diligently on grooming future executives on the strategic needs essential to run the business profitably in their NEW marketplace in the near future.

In order to groom the next generation of corporate management, planners must be absolutely clear on what tactical skill-requirements will be essential for corporate leadership and growth. A clear and unequivocal business plan in tandem with future leadership skill-set-deliverables is the integral ingredients necessary to ensure the success of leadership succession.

No one's saying the CEOs of the future have to be experts in all fields or in all disciplines. Nevertheless, it will be increasingly more important that senior exec's have a comprehensive understanding for the challenges and disciplines for which they are ultimately responsible and therefore must manage.

Although for some the challenge to find or make the next great corporate leader may seem daunting, we can take some comfort in what former President Ronald Reagan once said, "Great leaders are not measured by what great things they do but rather by what great things they get others to do."

Winners Never Cheat: Lessons for Today's Business Leaders

This is an excerpt from The "Winners Never Cheat" Book written by Jon M. Huntsman

In 1970, Jon M. Huntsman started a small entrepreneurial firm with his brother. By 2000, Huntsman Corp. had grown to become the largest privately held petrochemical and plastics business in the world. Today, Huntsman is a billionaire philanthropist who recently donated $225 million to establish the Huntsman Cancer Institute at the University of Utah. He has also contributed millions of dollars to help rebuild the country of Armenia; supported organizations that feed the poor, house the homeless and protect victims of domestic violence; and provided numerous high school students with college scholarships.

Huntsman himself was the recipient of an academic scholarship to Wharton where he received the Most Outstanding Graduate Award. He went on to earn an MBA and receive 12 honorary degrees from various universities. Since his graduation from Wharton, he has donated more than $50 million to the school.

He has earned the praise of people from all over the world. In 2001 he was presented with the Entrepreneur of the Year Award; in 2003 he received the Humanitarian of the Year Award from CNN's Larry King; and in 1994 he was given the Kaveler Award as the chemical industry's most outstanding CEO. Prior to that, the country of Armenia gave him its highest award -- the Medal of Honor. He is on the Board of Governors of the American Red Cross and chairman of its Biomedical Services Committee.

When Huntsman Corp. went public in early 2005, it had annual revenues exceeding $12 billion and major operations at 121 locations in 44 countries.

Winners Never Cheat is Huntsman's explanation of the principles at the heart of his business success. They include:

Compete fiercely and fairly -- but no cutting in line
• Set the example -- risk, responsibility, reliability
• Revenge is unproductive: Learn to move on
• Operate businesses and organizations as if they are family-owned.

Huntsman also stresses, among other principles, the importance of surrounding oneself with associates who listen to their conscience and act accordingly; of treating customers, colleagues, employees and competitors with respect; and of returning favors and good fortune by helping out those less fortunate.

Below is an excerpt from Winners Never Cheat.

Chapter 3: Play By the Rules

Compete fiercely and fairly -- but no cutting in line.

Which rules we honor and which we ignore determine personal character, and it is character that determines how closely we will allow our value system to affect our lives.

Early on, infused with moral purpose by those who influenced us, we learned what counted and what didn't. The Golden Rule, proper table manners, respecting others, good sportsmanship, the unwritten codes such as no cutting in line and sharing -- all these allowed us to develop character.

Character is most determined by integrity and courage. Your reputation is how others perceive you. Character is how you act when no one is watching. These traits, or lack thereof, are the foundation of life's moral decisions. Once dishonesty is introduced, distrust becomes the hallmark of future dealings or associations. The eighteenth-century Scottish philosopher Francis Hutcheson had this in mind: "Without staunch adherence to truth-telling, all confidence in communication would be lost."

Businessmen and -women do not place their integrity in jeopardy by driving hard bargains, negotiating intensely, or fiercely seeking every legitimate advantage. Tough negotiations, however, must be fair and honest. That way, you never have to remember what you said the previous day.

I bargain simply as a matter of principle, whether it is a $1 purchase or a $1 billion acquisition. Negotiating excites me, but gaining an edge must never come at the expense of misrepresentation or bribery. In addition to being morally wrong, they take the fun out of cutting a deal.

Bribes and scams may produce temporary advantages, but the practice carries an enormous price tag. It cheapens the way business is done, enriches only a few corrupt individuals, and makes a mockery of the rules of play.

In the 1980s, Huntsman Chemical opened a plant in Thailand. Mitsubishi was a partner in this joint venture, which we called HMT. With about $30 million invested, HMT announced the construction of a second site. I had a working relationship with the country's minister of finance, who never missed an opportunity to suggest it could be closer.

I went to his home for dinner one evening where he showed me 19 new Cadillacs parked in his garage, which he described as "gifts" from foreign companies. I explained the Huntsman company didn't engage in that sort of thing, a fact he smilingly acknowledged.

Several months later, I received a call from the Mitsubishi executive in Tokyo responsible for Thailand operations. He stated HMT had to pay various government officials kickbacks annually to do business and that our share of this joint obligation was $250,000 for that year.

I said we had no intention of paying even five cents toward what was nothing more than extortion. He told me every company in Thailand paid these "fees" in order to be guaranteed access to the industrial sites. As it turned out and without our knowledge, Mitsubishi had been paying our share up to this point as the cost of doing business, but had decided it was time Huntsman Chemical carried its own baggage.

The next day, I informed Mitsubishi we were selling our interest. After failing to talk me out of it, Mitsubishi paid us a discounted price for our interest in HMT. We lost about $3 million short term. Long haul, it was a blessing in disguise. When the Asian economic crisis came several years down the road, the entire industry went down the drain.

In America and Western Europe, we proclaim high standards when it comes to things such as paying bribes, but we don't always practice what we preach. Ethical decisions can be cumbersome and unprofitable in the near term, but after our refusal to pay "fees" in Thailand became known, we never had a problem over bribes again in that part of the world. The word got out: Huntsman just says no. And so do many other companies.

Once you compromise your values by agreeing to bribes or payoffs, it is difficult ever to reestablish your reputation or credibility. Therefore, carefully choose your partners, be they individuals, companies, or nations.

I have a reputation as a tough but straightforward negotiator. I deal hard and intensely -- and always from the top of the deck. Because it is perceived I usually end up on the better side of the bargain, I actually had one CEO refuse to negotiate a merger with me. He was afraid he would be perceived in the industry as having "lost his pants" or that he sold at the wrong time for the wrong price, but I have never had anyone refuse to deal with me for lack of trust.

Competition is an integral part of the entrepreneurial spirit and the free market. Cheating and lying are not. If the immoral nature of cheating and lying doesn't particularly bother you, think about this: They eventually lead to failure.

Remember the old chant: "Winners never cheat; cheaters never win"? And, as kids, we would chide those whom we perceived to be not telling the truth with: Liar, liar, pants on fire. Those childish taunts actually hold true today. Moral shortcuts always have a way of catching up.

In the Shinto religion, there is this teaching: "If you plot and connive to deceive people, you may fool them for a while and profit thereby, but you will without fail be visited by divine punishment." I hasten to add that temporal judgment also awaits. There is always a payback for indecent behavior.

Consider this parable: On a late-night flight over the ocean, the pilot announces good news and bad news. "The bad news is we have lost radio contact, our radar doesn't work, and clouds are blocking our view of the stars. The good news is there is a strong tailwind and we are making excellent time."

* * *

There are many professions in which one can find examples of hollow values, but nowhere is it more evident than on Wall Street, where the ruling ethos seems to be the more you deceive the other guy, the more money you make. It was none other than Abraham Lincoln who reminded us: "There is no more difficult place to find an honest man than on Wall Street in New York City."

I have spent nearly 40 years negotiating deals on Wall Street and have found few completely honest individuals. Those who are trustworthy and honorable are rare but wonderful professionals. Some of my closest friends are found in this small cadre, be they in New York City or Salt Lake City. Those who choose to mislead others discover that this is not the type of corruption that sends people to prison. It is more a matter of intellectual dishonesty and lack of personal ethics. Compensation has replaced ethics as a governing principle. Wall Street has but one objective and one value: How much money can be made?

Wall Street thinks there is nothing wrong with this sort of behavior because everyone does it, but the lack of a sense of integrity also produces a lack of respect. WorldCom, Tyco, Enron, and other giant companies had leaders who failed to play fair. Because they cheated, they lost. Accumulation of wealth became a driving force to these executives. They forgot the golden rule of integrity: Trust is a greater compliment than affection. With integrity comes respect.

Real winners never sneak to finish lines by clandestine or compromised routes. They do it the old-fashioned way -- with talent, hard work, and honesty. It's okay to negotiate tough business deals, but do it with both hands on the table and sleeves rolled up.

Make it a point to never misrepresent or to take unfair advantage of someone. That way, you can count on second and third deals with companies after successfully completing the first one. Have as a goal both sides feeling they achieved their respective objectives.

In 1999, I was in fierce negotiations with Charles Miller Smith, then president and CEO of Imperial Chemical Industries of Great Britain, one of that nation's largest companies. We wanted to acquire some of ICI's chemical divisions. It would be the largest deal of my life, a merger that would double the size of Huntsman Corp. It was a complicated transaction with intense pressure on each side. Charles needed to get a good price to reduce some ICI debt; I had a limited amount of capital for the acquisition.

During the extended negotiations, Charles' wife was suffering from terminal cancer. Toward the end of our negotiations, he became emotionally distracted. When his wife passed away, he was distraught, as one can imagine. We still had not completed our negotiations.

I decided the fine points of the last 20 percent of the deal would stand as they were proposed. I probably could have clawed another $200 million out of the deal, but it would have come at the expense of Charles' emotional state. The agreement as it stood was good enough. Each side came out a winner, and I made a lifelong friend.

* * *

Every family, home, and school classroom has its standards. There is little confusion over boundary lines. Even professing not to understand the rules when caught breaking one acknowledges a transgression has occurred. But what happens when some of these children turn into adults? Why are these home and classroom rules so ignored? Why is improper behavior rationalized, even justified, when inside we know better? Some sinister force must take over in the late teens in which finding ways to circumvent traditional standards becomes acceptable.

As a teenager, my father would order me to be home by 8 o'clock. He didn't say "a.m." or "p.m." I knew he meant 8 that night. There was no fine print to detail what was meant when he said he did not want "me" driving the family Ford. Although technically, he only said I shouldn't drive that 1936 Ford coupe, he was including my friends. (A lawyer might have counseled that, technically, only I was prohibited. Unless my dad specifically stipulated my buddy or class of people in that prohibition, anyone but me was legally allowed to drive, but I knew better.)

As we grow older, our rationale for not abiding by the rules would make a master storyteller green with envy. We blame situations or others. The dog ate the homework that we ignored. We rationalize that immoral behavior is accepted practice. Shifting responsibility away from ourselves has become an art form.

In fact, we employ the same feeble excuses we did as children when we were caught doing something improper, something we knew we shouldn't be doing. Adults believe they are more convincing. We aren't. The "everyone does it" line didn't work as a teenager, and it won't work now. It's a total copout and easily trumped. Everybody is not doing it. Even if they were, it still is wrong -- and we know it's wrong.

Then there's that old, sheepish excuse: "The devil made me do it." The devil never makes you do anything. Be honest. Improper actions often appear easier routes, or require no courage, or are temporarily advantageous.

If only Richard Nixon had admitted mistakes up front and taken responsibility for the improper conduct of his subordinates, something deep down he knew to be wrong, the American public would have forgiven him. With a sense of contrition, he could have created a presidential benchmark.

* * *

Children observe their elders so they know how to act. Employees watch supervisors. Citizens eye civic and political leaders. If these leaders and role models set bad examples, those following frequently follow suit. It's that simple.

There are no moral shortcuts in the game of business -- or life. There are, basically, three kinds of people: the unsuccessful, the temporarily successful, and those who become and remain successful. The difference is character.

In the Game of Business, Playing Fair Can Actually Lead to Greater Profits

A manufacturer and a retailer can both end up making more money if they are fair minded, setting prices with an eye to achieving an equitable outcome in their joint marketing channel as opposed to merely maximizing their individual profits, Zhang, Raju and Cui argue in a paper recently published in Management Science titled, "Fairness and Channel Coordination."

When people are fair minded, they don't need to waste time on elaborate negotiations or enter into complicated contracts to coordinate their marketing channel and maximize profitability, the authors contend in their paper. "A constant wholesale price will do. When a fair channel is coordinated through a constant wholesale price, the retailer perceives no inequity. Therefore, a constant wholesale price as a channel-coordination mechanism can help to foster an equitable channel relationship."

Here's how it works. When the retailer sees that he is being treated fairly by the manufacturer, he will reciprocate by picking a retail price that rewards the manufacturer. Because each gets an equitable share of the channel's profit, they won't squabble. "If you are fighting against each other, ultimately the whole channel will suffer," Zhang notes.

Conventional wisdom says that the manufacturer needs to enter into an elaborate contract with the retailer to align their interests. It may take the form of revenue sharing, quantity discounts or two-part tariffs. "In practice, you rarely see that," Zhang points out. "You mostly see a simple wholesale price contract. Given that, what's happening? What we show is that, as a retailer, you care about fairness: You want to be treated nicely, and you'll treat me nicely if I treat you that way."

For this kind of coordination to work, the retailer has to be able to ascertain the manufacturer's costs. Otherwise, he can't guage fairness of the wholesale price. "With transparency, it works better," Zhang says. "You would know what's fair and what's not." Without it, you have to rely simply on reputation and trust, which can take a long time to develop."

Transparency isn't a difficult condition to satisfy. Retailers typically have access to information on their suppliers' costs. This is true, for instance, "when the manufacturer supplies a standardized product or a commodity," the three scholars write. "In that case, competitive offers from manufacturers will reveal [significant cost information] to a retailer. This is also the case when the retailer engages in the private-label business and therefore knows quite a bit about manufacturers' cost structure."

Fairness over Profit Maximization

Zhang, Raju and Cui's model is rooted in the emerging field of behavioral economics. Behavioralists, as practitioners are known, have shown with experiments that people sometimes value fairness over profit maximization. In one such experiment, called the ultimatum game, one player receives a sum of money and gets to propose how to split it with a second player. The second player must accept the proposed division for either of them to receive any of the cash; if she rejects it, both end up with nothing. Classical economic theory suggests that the proposer should keep just about everything for himself -- say, 99% -- and offer just a crumb to the person across the table. That way, he has maximized his benefit, and the other player will accept because she's a bit better off than she was. In reality, responders typically reject splits in which they receive less than 20%. In some cultures, people will even reject splits of less than 50/50.

"The ultimatum game tells you that people aren't hard-nosed economists," Zhang says. "They are fair minded. And this kind of experimental outcome has strategic implications. We are saying that you don't need a hard-nosed attitude to make a profit in the real world. In some areas, fairness will address the channel relationship in such a way that everyone can be better off."

A model is necessarily a perfect microcosm. The three scholars' theory assumes that the retailer cares about fairness and shows how, if he does, that this can lead to better outcomes for both. But Zhang believes that it's a reasonable approximation of how people really conduct themselves. "This is behavior that we're indoctrinated in," he says. "It's hardwired in our head. If we behave unfairly, we feel bad about ourselves." It's why people don't typically propose 99/1 splits in the ultimatum game and why they reject divisions perceived as unfair.

Skunks and Chimps

Findings in the emerging field of neuroeconomics, which combines economics and neuroscience, reinforce these ideas, the scholars point out in their paper. Researchers have done magnetic resonance imaging (MRI) scans on people's brains while they are receiving offers like the ones in the ultimatum game. When subjects feel they have been cheated, a part of the brain called the anterior insula lights up --the same area that responds when they smell something disgusting, like a skunk.

Interestingly, chimpanzees recently have been shown not to be burdened by the same sort of economic scruples. A study conducted by scientists at the Max Planck Institute of Evolutionary Anthropology in Germany found that chimps had no concern for fairness. Working with trays and raisins, they would accept any division as long as they received at least one raisin, rejecting only offers where they got nothing. They were, in other words, more economically rational, at least in the classical sense, than humans.

Zhang acknowledges that, in the real world, people's conduct can resemble that of chimps. "You do have to watch out for opportunistic behaviors." Sometimes, social norms will prevent these people from trying to take advantage of those with whom they do business. They might be concerned about their reputation. Or if they have repeated interactions with someone else, they might act fairly out of fear of reprisal.

"When you don't have repeated interactions, that's when you have to worry," Zhang says. "It's like a tourist who doesn't leave a tip on the table because he thinks he'll never come back to the restaurant."

Large companies, because of their impersonality, might create situations where people care less about treating others fairly. That can be especially true if their employees are compensated for achieving short-term goals. "All else being equal, if you are working for a bigger company and you will get promoted if you make a short-term profit, you don't worry so much about fairness," Zhang says. "However, disregarding fairness can be detrimental to the company in the long run, as fairness is the lubricant for the sales machinery."

Losing an Employee Doesn't Have to Mean Losing Knowledge

It's always been assumed that one company's loss is another's gain when an employee jumps ship. Just think of the knowledge, experience and connections that go out the door along with a person's boxes and office belongings.

But now a new study suggests that losing an employee, at least in a high-tech field, is not necessarily as bad as it seems. "Firms can wind up learning when employees leave their firm, which is contrary to the conventional wisdom -- that firms learn by hiring away employees," says management professor Lori Rosenkopf. She and doctoral student Rafael A. Corredoira present their conclusions in a paper titled, "Learning from Those Who Left: The Reverse Transfer of Knowledge through Mobility Ties."

The two researchers came up with their silver-lining finding by studying the effects of "outbound mobility" on semiconductor firms in the United States and abroad. By analyzing patent citations, they were able to show that companies can benefit from a reverse flow of knowledge that results when an engineer or other technical expert moves on. Why? Because, according to Rosenkopf, there are social networks that transcend companies and allow the employees left behind to gain access to the knowledge being generated at their colleague's new place of business. She is not talking about corporate spying, but rather the flow of ideas and information among professionals who work in the same field. Their findings, she concludes, "call into question the conventional wisdom that losing employees means losing knowledge."

Other studies have looked at the opposite phenomenon -- "inbound mobility" -- documenting the transfer of knowledge that comes with hiring.

When people are viewed strictly as "human capital," the departure of an employee results in the former employer's loss of that person's intellect and talent, and the corresponding gain of those same valuable attributes for the company doing the hiring. "The belief has been that if you lose an employee, that's a bad thing for you," Rosenkopf says. Even common lingo -- that a company is losing a worker to another firm -- implies that there is nothing good that could possibly result.

But Rosenkopf says the picture is different when employees are viewed in terms of "social capital." Workers aren't just silos of knowledge and skill onto themselves, but rather are part of social networks of workers from various firms who talk about what's going on in their field. Those networks may involve formal arrangements, such as strategic alliances, but they may also be informal, involving professional conferences, email exchanges, common blog sites or even after-hour socializing.

"The social capital approach would predict that the firm losing an employee would gain access to the new employer's knowledge, while the human capital approach would not," the researchers suggest in their paper.

Six Degrees of Separation

The concept of social networks in not a new one, but it's getting more attention these days, both in the business world and in everyday life. ABC's much-anticipated new drama, "Six Degrees," is based on the popular notion that anyone, anywhere on the planet can be connected to another person by way of a chain of six people. It's an intriguing thought, though not a proven one.

In business, networks have long factored into who is picked for a board of directors, Rosenkopf says. Board members aren't necessarily selected for what they know about a particular industry or organization, but rather because they are seen as influential and well connected. In other words, whom you know does matter. On a lower level, inner-office networks play a role in how information flows around a company. The corporate organization chart only tells so much. Who chats with whom around the office and who is the person that people go to for advice also matter.

The value of networks is also well recognized in medicine and science, with researchers routinely reporting their research results and clinical experiences at conferences and in journals. The open sharing of knowledge is considered part of the scientific process.

The technological world may be different. According to Rosenkopf's paper, some previous research has drawn a distinction between the transfer of knowledge that takes place in science and the knowledge flow in high-tech industries. Some researchers believe that there isn't much exchange of ideas and information among tech companies because they compete with one another and want to make money. Rosenkopf, however, has looked at the cellular industry and found that informal networks, such as engineers taking part in professional and trade associations, lead to the formation of strategic alliances.

Contrary to the view that companies lose something when a worker leaves, the study found that they stood to gain. Specifically, firms that lost an employee to another firm were 8% more likely to cite that firm than other equivalent firms, Rosenkopf says. The reverse flow of knowledge was particularly pronounced when the employee moved to another region. Then the old firm was 22% more likely to cite the new firm. The outbound mobility effect held even when the researchers controlled for other factors that could influence patent citations, such as hiring, alliances and technological similarities between firms. "The effect of outbound mobility is actually stronger when the mobility occurs across regions," the researchers conclude.

The findings suggests that within a region, especially places such as Silicon Valley where there are many semiconductor firms, there may already be mechanisms in place for the sharing of knowledge. That would mean the effect of a worker moving to another firm would not be as pronounced.

The research paper looks at various reasons why knowledge flows back when a worker leaves. For one, new communication channels may be established between the old firm and the new firm -- in other words, a worker keeps talking to his former colleagues and friends. The departure of a worker may also cause a company to take a closer look at what's going on elsewhere.

"When an employee leaves one firm for another, his/her colleagues remaining at the prior employer can become more aware of the new employer as a site where knowledge worth knowing is being produced," the authors write. "By having one of their own going to that firm, work in the receiving firm gains credibility and saliency. The firm receiving the employee thus becomes more highly monitored for innovation opportunities."

The researchers used patent citations to sort out the payoff from outbound mobility compared to inbound mobility, or hiring. "An interesting puzzle in our results is that the effect of outbound mobility seems to be more robust, and although not significantly different, it is in general slightly larger than that of hiring," they reported.

The researchers looked at the effects of outbound mobility strictly in terms of patent citations, not financial effects, and it looked only at a high-tech business. In other businesses such as law or consulting, high-paying clients may go out the door with the worker. "While we suggest that the firm losing the employee increases the utilization of the body of knowledge of the firm receiving the employee, our study is not designed to address the economic implications of this activity," the authors write.

They also suggest that the findings shouldn't be seen as promoting the departure of workers. Still, "there are ways for the firm experiencing outbound mobility to obtain benefits from these events," the researchers said. Finally, Rosenkopf notes, firms need to keep things positive when a worker leaves. "Companies should be looking for making that parting as amicable as possible, to cultivate those ties as much as possible."

The going-away party -- at least at high-tech firms -- is about much more than sheet cake.

Why Do Good Managers Set Bad Strategies?

Errors in corporate strategy are often self-inflicted, and a singular focus on shareholder value is the "Bermuda Triangle" of strategy, according to Michael E. Porter, director of Harvard's Institute for Strategy and Competitiveness.

These were two of the takeaways from a recent talk by Porter -- titled "Why Do Good Managers Set Bad Strategies?" -- offered as part of Wharton's SEI Center Distinguished Lecture Series. During his remarks, Porter stressed that managers get into trouble when they attempt to compete head-on with other companies. No one wins that kind of struggle, he said. Instead, managers need to develop a clear strategy around their company's unique place in the market.

When Porter started out studying strategy, he believed most strategic errors were caused by external factors, such as consumer trends or technological change. "But I have come to the realization after 25 to 30 years that many, if not most, strategic errors come from within. The company does it to itself."

Destructive Competition

Bad strategy often stems from the way managers think about competition, he noted. Many companies set out to be the best in their industry, and then the best in every aspect of business, from marketing to supply chain to product development. The problem with that way of thinking is there is no best company in any industry. "What is the best car?" he asked. "It depends on who is using it. It depends on what it's being used for. It depends on the budget."

Managers who think there is one best company and one best set of processes set themselves up for destructive competition. "The worst error is to compete with your competition on the same things," Porter said. "That only leads to escalation, which leads to lower prices or higher costs unless the competitor is inept." Companies should strive to be unique, he added. Managers should be asking, "How can you deliver a unique value to meet an important set of needs for an important set of customers?"

Another mistake managers make is relying on a flawed definition of strategy, said Porter. "'Strategy' is a word that gets used in so many ways with so many meanings that" it can end up being meaningless. Often corporate executives will confuse strategy with aspiration. For example, a company that proclaims its strategy is to become a technological leader or to consolidate the industry has not described a strategy, but a goal. "Strategy has to do with what will make you unique," Porter noted. Companies also make the mistake of confusing strategy with an action, such as a merger or outsourcing. "Is that a strategy? No. It doesn't tell what unique position you will occupy."

A company's definition of strategy is important, he said, because it predefines choices that will shape decisions and actions the company takes. Vision statements and mission statements should not be confused with strategy. Companies may spend months negotiating every word, and the results may be valuable as a corporate statement of purpose, but they do not substitute for strategy.

In the last 10 years or so, Porter added, companies have become increasingly confused about corporate goals. The only goal that makes sense is for companies to earn a superior return on invested capital because that is the only goal that aligns with economic value.

Recently, companies have developed "flaky metrics of profitability," he said, pointing to amortization of good will as an example. Some of these measures began as a way for managers to stay a step ahead of the demands of Wall Street. "What starts as a game for capital markets then starts to confuse the managers themselves. They [then] make decisions that are not based on fundamental economics."

Porter said the "Bermuda Triangle of strategy" is confusion over economic performance and shareholder value. "We have had this horrendous decade where people thought the goal of a company is shareholder value. Shareholder value is a result. Shareholder value comes from creating superior economic performance."

To think that stock price on any one day, or at any one minute, is an accurate reflection of true economic value is dangerous, he noted. Research shows companies can be undervalued for years. Conversely, during the Internet bubble, managers whose motivation and compensation were tied to stock price began to believe and act as if the share price determined the value of the company. Managers are now beginning to understand the goal of their companies is to create superior economic performance that will be reflected in financial results and eventually the stock price. "We know there's a lag and it's ugly. But it's important that a good manager understands what the real goal is -- not spend time pleasing the shareholders."

Corporate strategy cannot be done without strong quantitative analysis, said Porter, adding that each year students take his strategy course thinking they will have at least one class in which they don't have to worry about numbers. Not true. "Any good strategy choice makes the connection between the income and the balance sheet."

Right Time, Right Price

Companies hoping to build a successful strategy need to define the right industry and the right products and services. Bad strategy often flows from a bad definition of the business, said Porter.

He pointed to Sysco Corp., the number-one foodservice supplier in North America. Defining Sysco simply as a food distribution firm would eventually lead to a failed strategy. The industry is actually two distinct sectors. One delivers food to small restaurants and institutions that need help with finance and product selection. The other has large, fast food franchise customers, like McDonald's, that are not interested in any additional services. McDonald's just wants industrial-size containers delivered on time at the best price. Sysco has developed two separate strategies for its two customers.

Geographic focus is another type of business definition that can trip up strategy. He gave the example of a U.S. lawn care company that developed a plan to grow through international expansion. The business, however, was not suited to operating on a global scale. The products were bulky and expensive to ship, and the company had to deal with different retail channels in different regions.

One more mistake managers make is confusing operational effectiveness with strategy. Operational effectiveness is, in essence, extending best practices. Good operations can drive performance, Porter said, but added: "The trouble with that is it's hard to sustain. If it's a best practice, everybody will do it, too."

None of this is easy, he conceded. "The real challenge of management is you have to do these things together at the same time. You have to keep up with best practices while solidifying, clarifying and enhancing your unique positions."

Managers often tend to let incremental improvements in operations crowd out the larger strategy of building a unique business that will retain its competitive advantage, Porter noted. To bypass this problem, managers must keep the competitive strategy in mind at all times. "Every day, every meeting, every decision, has to be clear.... Is this an operational best practice or is this something that's improving on my strategic distinction?"

He went on to describe key principles of strategic positioning, including a unique value proposition, a tailored value chain, clear tradeoffs in choosing what not to do, and strategic continuation, or ongoing improvement. The underpinnings of strategy are "activities that fit together and reinvigorate each other."

Enterprise Rent-A-Car is an example of a company that stumbled onto its strategy more or less by luck, according to Porter. The company started as an auto-leasing firm, but customers frequently asked if they could rent cars for short periods. The rental car industry was completely geared toward travelers, with pick-ups at airports and a price structure suited to expense accounts or vacationers willing to splurge.

It is difficult to sustain the kind of strategic advantage Enterprise enjoys without a patent, Porter pointed out. Hertz has tried to connect with this business but remains geared toward the traveler and cannot compete with Enterprise in its specific market.

Porter stressed that continuity is critical to successful strategy. "If you don't do it often, it's not strategy," said Porter. "If you don't pursue a direction for two or three years, it's meaningless." Many companies start out with a good strategy, but then grow their way into failure, Porter continued. Research shows that among companies that fade in 10 years, many enjoyed phenomenal growth in the beginning, but then put growth ahead of sticking to their strategy.

Dividends are one way to avoid the pressure to boost stock price with rapid growth, Porter said. Dividends also return capital to all investors, not just short-term investors who benefit from trading on gains in share price.

Leadership and Strategy

Porter cited some capital market biases that result in barriers to strategy. First, Wall Street tends to create pressure for companies to emulate their peers. He said analysts often anoint a star performer in each industry, which encourages others to follow that company's game plan. Again, this leads to the no-win approach of companies competing on the same dimensions, not on unique strategies.

Analysts also tend to choose metrics that are not necessarily aligned with true value or meaningful for all strategies, said Porter, noting that analysts apply pressure to grow fast and have a strong bias toward deals, which lead to a quick bump in the stock early on. Managers are made to feel like "Neanderthals" if they resist mergers and acquisitions or other financial market tactics, he added. "What happened in a lot of companies was that the equity compensation was [tied to share price] and people became crazed and very attentive to these biases. All the corporate scandals came from pressure to do things that were stupid."

Other barriers to strategy include industry conventional wisdom; labor agreements or regulations that constrain choice; inappropriate cost allocation to products or services, and rapid turnover of leadership. Increasingly, he is struck by how important leadership is to strategy. "Strategy is not something that is done in a bottom-up consensus process. The companies with really good strategy almost universally have a very strong CEO, somebody who is not afraid to lead, to make choices, to make decisions." Strategy is challenged every day, and only a strong leader can remain on course when confronted with well-intentioned ideas that would deviate from the company's strategy. "You need a leader with a lot of confidence, a lot of conviction and a leader who is really good at communication."

Years ago, corporate strategy was considered a secret known only by top executives for fear competitors might use the information to their advantage, said Porter. Now it is important for everyone in the organization to understand the strategy and align everything they do with that strategy every day. Openness and clarity even help when coping with competition. "It's good for a competitor to know what the strategy is. The chances are better that the competitor will find something else to be unique at, instead of creating a zero-sum competition."

If You Were in Charge, How Would You Market These Products?

A summer blockbuster movie and a cell phone

With more and more advertising vehicles crowding today's marketing environment -- including traditional print, television and radio ads, product placements, Internet buzz, viral campaigns and cell phone messaging -- marketers have new opportunities to reach vast pools of potential customers.

But the tangle of options also requires any successful marketing plan to take into account the nature of the product, its durability in the public's mind and the advertising budget needed to make it all work. It's very hard to find "the one big lever that can reach a whole lot of people in a way that is cost-effective."

Go for the Soft Launch

According to Eric Bradlow, no matter what the product, marketers should consider a preliminary soft launch in sample markets to determine what works best before investing in a full-scale campaign. "You have to measure the efficiencies of any given vehicle. Many companies run test launches because, as the number of options expands, it makes it more difficult for a company to know how to allocate its advertising dollars. Before I spend a lot of money, I would want to empirically validate what is going to work."

Bradlow suggests that the producers of a blockbuster action film do pre-launch advertising in several different ways. First, they should form co-branding deals with manufacturers of products to extend awareness of the movie beyond theater aisles. He also suggests sending clips to web sites to create early buzz about the upcoming film, as well as showing trailers in theaters screening similar films that might draw the same audience back for the coming attraction. "The pre-launch is to build the hype around the movie, but you must make sure you are targeting the right segment. If you are thinking about spending marketing dollars efficiently, you need to reach the most appropriate audience."

A new cell phone might benefit from product placements -- in which marketers pay to place their product in television and/or movie scenes as a more subtle form of advertisement, says Bradlow. Yet while product placement "can be an effective way to get high initial visibility, it can also be controversial. Producers of movies, sitcoms, and so forth are reluctant to do product placement too much because they feel it hurts the integrity of their shows. Also, it's not really known what the optimum level of product placement is." For example, the first couple of times you see Dr. Pepper in a movie, Bradlow adds, "it increases your awareness and is good for the product. But by the fiftieth time, you're probably going to like Dr. Pepper less."

Cell phone give-aways to celebrities or to consumers on a free-trial basis would also help generate word-of-mouth about the products, Bradlow says, noting, however, that many cell phones are now considered to be a commodity -- an ancillary item that comes with a wireless service plan. "To move it away from becoming a commodity, you might want to connect it to a show or a star to differentiate it" from other cell phones that technically many have the same features.

Smash Hit or Big Bomb?
According to Jehoshua Eliashberg, who studies the entertainment industry, movie-marketing strategies differ depending on whether the studio believes it has a hit on its hands, or smells a bomb. Studios now test films with small audiences in the weeks before the movie is released to gauge reactions. If the movie is not doing well, Eliashberg says the studio should advertise it on television, in print and on some outdoor billboards. "I would do it very close to the release date and I would prevent any special showings to the critics," he says.

Eliashberg points to the release of the 2003 film Gigli, starring Ben Affleck and Jennifer Lopez, as an example of a film that the studio kept away from critics as long as possible. When it was released, the movie was widely panned. That strategy, however, has its limits because audiences now know that if critics are not given early screenings, the movie is likely to be flawed, Eliashberg says.

This spring, Sony kept the widely anticipated movie The Da Vinci Code away from critics and it has met with lukewarm reviews. "It's hard for me to tell whether Sony made a deliberate decision not to let the critics see the movie because of what the reviews might say, or whether it felt the movie had generated enough controversy -- and awareness was high enough -- that there was no upside to previews, only a downside," Eliashberg notes.

With a bad movie, the strategy is for the studio to remain in control of the marketing and avoid spontaneous word-of-mouth. On the other hand, if the film is a gem, studios should go all out to promote buzz in public, says Eliashberg. "If the testing indicates I have something that is really good, then my strategy will be different. I will go with email and viral or buzz marketing. I will spend less on TV because that is the most costly media vehicle. The rationale is, if I know it will generate positive word-of-mouth, I can save the money I would spend on TV ads."

Eliashberg says the Internet is already used as a place to market movies, with viewers passing along video clips and trailers at social network sites. He points to a new viral strategy used last year to promote the thriller Lucky Number Slevin. The studio posted the first eight minutes of the film on the movie's web site. "I'm not talking about an advertising trailer in which they show different scenes. I'm talking about giving consumers an opportunity to observe the first 10 minutes or so of the movie with the rationale being that this will whet their appetite and encourage them to start sending those video clips to others and generate demand."

This sort of viral campaign is easier to conduct than a so-called buzz campaign, which requires companies to identify opinion leaders and then convince them to market a product, Eliashberg suggests. Procter & Gamble Co., for example, has a new word-of-mouth campaign called Vocalpoint, in which 600,000 mothers, labeled "connectors", were recruited to promote P&G products with coupons and free samples.

Trying to Keep up the Buzz

According to David Schmittlein, buzz marketing campaigns can be more expensive than they might seem. "I have seen some field tests saying these campaigns can make a real difference in sales, but the challenge is to keep the costs low enough that the real and substantial pay-off isn't overwhelmed by what you have to pay to get the buzz activity," he notes. "Even if you are just doing the usual kinds of freebie promotions to the buzz agents ... it's hard to make [the effort] pay for itself." It's not hard for marketers to encourage buzz agents to talk about the products initially, Schmittlein adds. "The challenge has been to get those people to keep talking to one another in such a way that it doesn't break the bank."

When it comes to marketing a summer action film, Schmittlein advises studios to seek out young males -- likely viewers of this type of movie. Sports programming, particularly on cable television, as well as web sites such as those produced by Sports Illustrated and ESPN, would be a place to start, he says, noting, however, that a viral campaign over the Internet might be hard to pull off. "It's difficult to think of a very good outbound e-mail to young males. There are some sites that will [send promotional email] if the [users] have already indicated an interest in movies, but that's a small fraction of young males. It's not good coverage overall."

In some countries, particularly China and Japan, advertisers could launch a cell phone campaign to interest viewers in a new movie, Schmittlein adds, pointing out that in the United States, most cell phones lack the technology to make this kind of marketing effort pay off. "The video cell phone campaigns are coming, but the amount of market penetration you can get is still limited. It's a place where advertisers want to experiment; they are seeing what works and what doesn't work. But it's hard to build around a cell phone campaign."

He says the future of cell phone marketing in the United States will depend on whether consumers want to view content on a tiny screen, and whether they will pay for new video cell phone content or be willing to view advertising that would reduce the cost.

To market a new cell phone itself, Schmittlein agrees that many of them have become commodities that depend more on the marketing efforts of wireless carriers. Spotty national wireless coverage causes problems when attempting to do television or print campaigns. To buy television time in individual markets adds about 25% to the cost of a campaign compared to a full national advertising purchase, he adds.

Hot Pink and Blue Models

According to David Bell, for a summer blockbuster film aimed at a wide audience, marketers should focus on broad-based media such as newspaper and television advertisements. By contrast, an avant-garde film likely to appeal to a smaller set of viewers would call for a more targeted campaign using the Internet or possibly cutting-edge cell phone advertising. "The nature of the audience and the content of the movie dictate what media one would use," he notes. For a movie with merchandise tie-ins, such as action figures, toys or t-shirts, Bell suggests marketers co-promote the film with fast-foot outlets or retailers with a broad reach.

Marketing a new cell phone requires strategic advertising decisions to be based on the nature of the product, says Bell. If the phone is a basic model, marketers might simply let it be handled through wireless carriers and broad marketing campaigns on television and in newspapers. If the phone is designed to be more of a fashion accessory, marketers could try to develop social components in their campaign, such as a celebrity endorsement, Bell adds. For example, Madonna has promoted the super-slim Motorola Razr, which comes in hot pink and blue models.

Marketers with a phone that does have an edge with a new function, such as video or music capability, should focus on that, Bell advises. "The company should try something edgier. I might try to add something a little less traditional to generate some buzz around the product and promote it among particular users."

According to Bell, increasingly customized products and correspondingly complex marketing strategies can backfire if they overwhelm consumers. He points to Yellowtail, the Australian wine, as an example of a product that has been successful, mainly because, with a plain yellow label, it is simple and easy to understand. "It may not be the best wine, but for a large segment [of the market] it is very recognizable and simple. People know that if they buy it, they will be doing well enough."

The complexity that is now part of the marketing world represents a structural change and is not likely to recede, Bell adds. "We have turned the corner and can never go back to a world of homogenization."

The Price Is Right, but Maybe It's Not, and How Do You Know?

When Apple dropped the price of its iPhone by a third after only two months on the market, even its most loyal buyers complained bitterly, forcing chief executive Steve Jobs to apologize and offer a partial rebate.

The iPhone episode reveals the perils of pricing in a marketplace where constant innovation, fierce competition and globalization are changing the rules of the game. "The product lifecycle is short and the market is moving quickly," marketing professor John Zhang. "You don't have a lot of time to learn from your mistakes. You have to price the product right the first time."

Pricing is gaining new interest as management looks for ways to increase revenues after years of focusing their attention on downsizing and cost-cutting. Firms are only now beginning to apply to pricing some of the data collection and management tools they have been using in supply chain management and other parts of their businesses. "Pricing is the last bastion of gut feel," says Greg Cudahy, managing partner of Accenture's pricing and profit optimization practice.

According to Cudahy, companies that take a strategic approach to pricing throughout their business and monitor their success with hard numbers can raise revenue by between 1% and 8%. "That's a huge shift in pure revenue improvement."

For example, New York drugstore chain Duane Reade increased baby product revenues by 27% after using pricing software to examine sales data, according to an article titled, "The Price Is Right...Isn't It?" that appeared in the January 2007 edition of Accenture's business publication Outlook. In the article, Cudahy and George L. Coleman, a leader of Accenture's retail pricing group, describe how the data showed that parents of newborns are not as price-sensitive as parents of toddlers. In response, the company cut prices on toddler diapers to remain competitive with other stores and raised prices on diapers for infants.

Cudahy says better pricing can help businesses on many other levels beyond revenue boosts. For example, he worked with a parcel delivery company that introduced a coherent pricing strategy to its operations and found it was able to reduce by 90% the time spent working out pricing for bids. That allowed the company to focus more time and effort on building up customer relationships.

Closer attention to pricing can have payoffs in other ways, he says. Accenture found that in some retail operations a price decrease in one area can lead to beneficial pricing elsewhere in the store. Research in retirement communities in the South, for example, observed that shoppers had a high sensitivity to the price of health care goods. But saving a few cents on those items may lead them to spend 50 cents more on other items. "Pricing is not only about trying to get people to pay more," he says. "Pricing is used as a testing mechanism to find what consumers really want. It's basic supply and demand. The surest way to find out if consumers want something is their willingness to pay for it."

'Temporal Price Discrimination'

Apple's price cut is an example of a strategy known as "temporal price discrimination." Companies using this strategy charge people different prices depending on the buyer's desire or ability to pay. As a result, companies win two ways. First, they reap wide profit margins from those willing to pay a premium price. In addition, they benefit from high volume, even at a lower per unit price, by building a wider customer base for the product later. Raju notes that price discrimination can also be structured across geographies, seasons and by adding or eliminating features, as is done with student software.

Consumers have come to accept this form of pricing in the airline industry. A last-minute traveler expects to pay vastly more than a frugal flyer who booked a seat on the same flight, in the same aisle, months earlier on the Internet. It is easier, Raju says, to apply temporal pricing structures in an industry with a service component -- like airlines -- than it is with a tangible manufactured item. Indeed, just last week, New York City's transit agency proposed a two-tier system under which people would pay a lower fare if they ride subways or buses during off-peak periods. The plan, which would take effect in 2008, would raise agency revenues as well as offset overcrowding. And, according to a report in the New York Times, the Bush administration is considering a plan to charge airlines higher fees for landing during an airport's rush hour than for landing during off-peak hours.

However, temporal pricing can be applied to other non-service industries as well, including the technology sector, where consumers expect to pay sharply lower prices if they are willing to hold off on buying an exciting new product the minute it hits the market. In many cases, Raju says, technology marketers must set pricing below profitable levels to build an installed user base that will lead to profitable levels of sales volume later. "If I'm the only one with a video phone, whom am I going to call?" Raju asks.

While pricing discrimination makes sense for businesses, it can be a touchy issue. He recalls that Coca-Cola faced a harsh backlash when it tried to charge more for drinks at vending machines on warm days than on cold ones. Coke ultimately backed down. Price discrimination "is a new phenomenon that is growing. But you must approach it very delicately as Coca-Cola found out." He says professional sports teams are beginning to think about charging more for highly sought-after games, and grocery stores in Manhattan have experimented with charging less for items during the day when stores are not as crowded and consumers have more time to comparison shop.

At the moment, the acceptance of pricing discrimination varies widely among product categories, according to Reibstein. While consumers have long accepted the idea of matinee prices and senior-citizen discounts, they are outraged when street vendors jack up the price of umbrellas on a rainy day and they would never expect to receive a senior citizen discount on a new car. Reibstein says the best way to inaugurate a price discrimination scheme is to be open about the economic reasoning behind the decision. Don't "try and sneak it past the public. Be very open and honest about your rationale for doing it."

Frank Luby, a partner in the Boston office of the price consulting firm Simon-Kucher & Partners (SKP), cautions that many companies fail to take into account how their competitors will react when they lower their prices. Continued price responses among competitors can lead to an all-out price war that can be disastrous for all sides. "We would argue, in some cases, that the best response to a potential price war is none," says Luby.

He also notes that companies must take "price contamination" into account when developing pricing strategy. At the business-to-business level, the power of pricing discrimination erodes as employees move from firm to firm sharing internal information about pricing. Acquisitions also put pressure on prices as companies open their books to one another and see disparities. "What you charge one place has a risk of leaking out and coming back to haunt you. That's an incentive to keep prices as high as possible."

According to Raju, certain industries are more advanced than others in developing successful pricing strategies. In addition to airlines and mobile phones, retailers are among the most sophisticated. Wal-Mart, for example, collects detailed customer and competitor data to make pricing decisions. The apparel industry, he says, is not as complicated. Clothing retailers charge high prices when garments arrive at the beginning of a season, but then systematically make markdowns as the season progresses. "The value of the product lowers as time goes by."

Pricing is growing increasingly complex as companies expand into new markets around the world, Raju notes. "As globalization takes over, there is wide variation in willingness to pay, yet the markets are very attractive. How do you go after people who don't have high income, but whom you would like to have touch your product?"

The pharmaceutical industry, he adds, has attempted to create differential pricing structures to reach patients in developing countries while protecting profits in their traditional markets in Europe and the United States.

Zhang says companies are realizing that pricing is critically important, but difficult to do right. Typically, managers have avoided new approaches to pricing, not only because it is complex but also because it is so important. "If the decision is impactful, you don't want to do anything new. If you don't have a very sophisticated knowledge of pricing, you don't have the confidence to make those kinds of decisions. The safe thing to do is to follow whatever the convention is." Usually, he says, companies take their cost to produce a product and add a certain percentage to that as profit. Isuppli, a technology market research firm, has estimated the cost to produce the 8GB iPhone at $265.83.

Zhang points out that another obstacle to pricing new products, particularly technology gadgets, is an inability to do wide market tests without trading off the secrecy necessary to protect a developing product from copycats.

Part of the Family

Often pricing defies traditional models when products carry an emotional attachment or become a symbol of the owner's sense of self, which can happen with cars, handbags and technology products, including phones and music players.

The reversal on Apple's iPhone may have been more dramatic because the company has marketed itself as consumer friendly. "People have strong positive feelings about Apple. They feel they are part of the Apple family." When Jobs announced the price decrease, "people felt betrayed. I don't know whether they should or not. It's not as though this is the first time a technology company lowered prices."

Hoch says he does not believe Apple was under pressure to boost unit sales because of lower-than-expected purchases. He notes that the company sold one million phones in a little more than two months, nearly a month ahead of its announced target. To compare, it took Apple two years to sell one million iPods. While the iPod was more or less in a class by itself, the iPhone is a new player in a fully developed, competitive cellular phone market. "The competitors will work hard to defend their positions. There will be a lot of new products and pricing."

For Luby, the iPhone pricing controversy shows that even a sophisticated marketer like Apple can be tripped up by the complexity and hidden effects of a pricing decision. "It seems like Apple made a mistake -- and many people believe it did -- but there are a lot of moving parts here." He points to the phone's new features, its exclusive tie to wireless carrier AT&T and all the hype associated with its launch. He challenges Apple's critics to present a model of how they would tease out all these elements to determine the right price: "I'd like to see their math."