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Management

McGraw−Hill Primis

ISBN: 0−390−55206−2

Text: Effective Behavior in Organizations, Seventh EditionCohen

Harvard Business Review Industry and Competitive Strategy Articles

Harvard Business School POM Cases Harvard Business Review Service Management Articles

Contemporary Management, Fourth EditionJones−George

Course:Health Care AdministrationMBAHC−9

California College for Health SciencesMBA Health Care Program

McGraw-Hill/Irwin��

Management

http://www.mhhe.com/primis/online/Copyright ©2005 by The McGraw−Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without prior written permission of the publisher. This McGraw−Hill Primis text may include materials submitted to McGraw−Hill for publication by the instructor of this course. The instructor is solely responsible for the editorial content of such materials.

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Management

Contents

Jones−George • Contemporary Management, Fourth Edition

I. Management 1

2. The Evolution of Management Thought 1

Cohen • Effective Behavior in Organizations, Seventh Edition

11. Leadership: Exerting Influence and Power 35

Text 35

Harvard Business Review Service Management Articles

Deregulation and Regulatory Backlash in Health Care 62

Article 62


Finding a Lasting Cure for U.S. Health Care 83

Article 83

Harvard Business School POM Cases

Deaconess−Glover Hospital (A) 99

Case 99


Making Competition in Health Care Work 123

Article 123

Will Disruptive Innovations Cure Health Care? (HBR)(OnPoint)(Enhanced)(Edition) 139

Article 139

iii

Jones−George: Contemporary Management, Fourth Edition

I. Management 2. The Evolution of Management Thought

1© The McGraw−Hill Companies, 2005

2CHAPTER

Learning ObjectivesAfter studying this chapter, you should be able to:

• Describe how the need toincrease organizationalefficiency and effectiveness hasguided the evolution ofmanagement theory.

• Explain the principle of jobspecialization and division oflabor, and tell why the study ofperson-task relationships iscentral to the pursuit ofincreased efficiency.

• Identify the principles ofadministration and organizationthat underlie effectiveorganizations.

• Trace the changes in theoriesabout how managers shouldbehave to motivate and controlemployees.

• Explain the contributions ofmanagement science to theefficient use of organizationalresources.

• Explain why the study of theexternal environment and itsimpact on an organization hasbecome a central issue inmanagement thought.

CHAPTER

The Evolution of Management Thought



2 © The McGraw−Hill Companies, 2005

A Manager’sChallenge

What Kind of PersonalComputers Do Customers

Want?

What is the best way to use people’s skills?

Car production has changed dramatically over

the years as managers have applied different

principles of management to organize and con-

trol work activities. Prior to 1900, small groups

of skilled workers cooperated to hand-build

cars with parts that often had to be altered and

modified to fit together. This system, a type of

small-batch production, was very expensive;

assembling just one car took considerable time

and effort; and skilled workers could produce

only a few cars in a day. Although these cars

were of high quality, they were too expensive.

Managers of early car companies needed bet-

ter techniques to increase efficiency, reduce

costs, and sell more cars.

Henry Ford revolutionized the car indus-

try. In 1913, Ford opened the Highland Park

car plant in Detroit to produce the Model T

Ford, and his team of manufacturing man-

agers pioneered the development of mass-

production manufacturing, a system that

made the small-batch system almost obso-

lete overnight. In mass production, moving

conveyor belts bring the cars to the workers.

Each worker performs a single assigned

A Manager’s ChallengeFinding Better Ways to Make Cars

(a) The photo on top, taken in 1904 inside a Daimler Motor Company factory,is an example of the use of small-batch production, a production system inwhich small groups of people work together and perform all the tasksneeded to assemble a product. (b) In 1913, Henry Ford revolutionized theproduction process of a car by pioneering mass production manufacturing, aproduction system in which a conveyor belt brings each car to the workers,and each individual worker performs a single task along the production line.Even today cars are still built using this system, as evidenced in the photo ofworkers along a modern-day computerized automobile assembly line.




42 Chapter Two

task along a production line, and the speedof the conveyor belt is the primary means ofcontrolling workers’ activities. Ford experi-mented to discover the most efficient way foreach worker to perform an assigned task.The result was that each worker performedone narrow, specialized task, such as boltingon the door or attaching the door handle, andjobs in the Ford car plant became very repet-itive. They required little use of a worker’sskills.1 Ford’s management approach in-creased efficiency and reduced costs by somuch that by 1920 he was able to reduce theprice of a car by two-thirds and to sell morethan 2 million cars a year.2 Ford became theleading car company in the world, and com-petitors rushed to adopt the new mass-pro-duction techniques.

The next change in management thinkingabout car assembly occurred in Japan whenOhno Taiichi, a Toyota production engineer,pioneered the development of lean manufac-turing in the 1960s after touring the U.S. plantsof the Big Three car companies. The manage-ment philosophy behind lean manufacturing isto continuously find methods to improve theefficiency of the production process in order toreduce costs, increase quality, and reduce carassembly time. Lean production is based onthe idea that if workers have input and can par-ticipate continually in the decision-makingprocess, their skills and knowledge can beused to increase efficiency.

In lean manufacturing, workers work on amoving production line, but they are organizedinto small teams, each of which is responsiblefor a particular phase of car assembly, such asinstalling the car’s transmission or electricalwiring system. Each team member is expectedto learn the tasks of all members of that team,and each work group is responsible not only forassembling cars but also for continuously find-ing ways to increase quality and reduce costs.By 1970, Japanese managers had applied thenew lean-production system so efficiently that

they were producing higher-quality cars atlower prices than their U.S. counterparts. By1980 Japanese companies dominated theglobal car market.

To compete with the Japanese, managersof U.S. carmakers visited Japan to learn thenew management principles of lean produc-tion. As a result, companies such as GeneralMotors (GM) established the Saturn plant toexperiment with this new way of involvingworkers; GM also established a joint venturewith Toyota called New United Motor Manufac-turing Inc. (NUMMI) to learn how to achievethe benefits of lean production. Meanwhile,Ford and Chrysler began to change their workprocesses to take advantage of employees’skills and knowledge.

In the 1990s global car companies in-creased the number of robots used on theproduction line and began to use advancedIT to build and track the quality of cars beingproduced. Indeed, for a time it seemed thatrobots rather than employees would be build-ing cars in the future. However, Toyota dis-covered something interesting at its fullyroboticized car plant. When only robots buildcars, efficiency does not continually increasebecause, unlike people, robots cannot pro-vide input to improve the work process. Thecrucial thing is to find the right balancebetween using people, computers, and IT.

In the 2000s, global car companies arecontinuing to compete fiercely to improve andperfect better ways of making cars. Toyota isconstantly pioneering new ways to manageits assembly lines to increase efficiency; how-ever, other Japanese carmakers such as Nis-san are catching up fast. U.S. carmakers arecatching up too: Ford, which made majoradvances in the 1990s, has now been sur-passed by both Chrysler and GM. Bothannounced in 2004 that their productivity wasfast approaching that of Japanese companiesand that they expected to match the leaders,Toyota and Nissan, within the next 10 years.

As this sketch of the evolution of management thinking inglobal car manufacturing suggests, changes in management

practices occur as managers, theorists, researchers, and consultants seek newways to increase organizational efficiency and effectiveness. The driving force

Overview




behind the evolution of management theory is the search for better ways to uti-lize organizational resources. Advances in management thought typically occuras managers and researchers find better ways to perform the principal manage-ment tasks: planning, organizing, leading, and controlling human and otherorganizational resources.

In this chapter, we examine how management thought has evolved in mod-ern times and the central concerns that have guided ongoing advances in man-agement theory. First, we examine the so-called classical management theoriesthat emerged around the turn of the 20th century. These include scientific man-agement, which focuses on matching people and tasks to maximize efficiency,and administrative management, which focuses on identifying the principlesthat will lead to the creation of the most efficient system of organization andmanagement. Next, we consider behavioral management theories developedboth before and after World War II; these focus on how managers should leadand control their workforces to increase performance. Then we discuss manage-ment science theory, which developed during World War II and has becomeincreasingly important as researchers have developed rigorous analytical andquantitative techniques to help managers measure and control organizationalperformance. Finally, we discuss business in the 1960s and 1970s and focus onthe theories developed to help explain how the external environment affects theway organizations and managers operate.

By the end of this chapter you will understand the ways in which managementthought and theory have evolved over time. You will also understand how eco-nomic, political, and cultural forces have affected the development of these theoriesand the ways in which managers and their organizations behave. In Figure 2.1 wesummarize the chronology of the management theories discussed in this chapter.

The Evolution of Management Thought 43

Scientific Management Theory

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Administrative Management Theory

Behavioral Management Theory

Organizational Environment Theory

Management Science Theory

Figure 2.1The Evolution of ManagementTheory

The evolution of modern management began in the clos-ing decades of the 19th century, after the industrial revolu-tion had swept through Europe and America. In the neweconomic climate, managers of all types of organizations—political, educational, and economic—were increasingly try-ing to find better ways to satisfy customers’ needs. Many

major economic, technical, and cultural changes were taking place at this time. Theintroduction of steam power and the development of sophisticated machinery and

ScientificManagement

Theory




equipment changed the way goods were produced, particularly in the weaving andclothing industries. Small workshops run by skilled workers who produced hand-manufactured products (a system called crafts production) were being replaced bylarge factories in which sophisticated machines controlled by hundreds or eventhousands of unskilled or semiskilled workers made products. For example, rawcotton and wool, which in the past had been spun into yarn by families or wholevillages working together, were now shipped to factories where workers operatedmachines that spun and wove large quantities of yarn into cloth.

Owners and managers of the new factories found themselves unprepared forthe challenges accompanying the change from small-scale crafts production tolarge-scale mechanized manufacturing. Moreover, many of the managers andsupervisors in these workshops and factories were engineers who had only atechnical orientation. They were unprepared for the social problems that occurwhen people work together in large groups in a factory or shop system. Man-agers began to search for new techniques to manage their organizations’ re-sources, and soon they began to focus on ways to increase the efficiency of theworker-task mix.

Job Specialization and the Division of LaborInitially, management theorists were interested in the subject of why the newmachine shops and factory system were more efficient and produced greaterquantities of goods and services than older, crafts-style production operations.Nearly 200 years before, Adam Smith had been one of the first writers to inves-tigate the advantages associated with producing goods and services in factories.A famous economist, Smith journeyed around England in the 1700s studyingthe effects of the industrial revolution.3 In a study of factories that produced var-ious pins or nails, Smith identified two different manufacturing methods. Thefirst was similar to crafts-style production, in which each worker was responsiblefor all of the 18 tasks involved in producing a pin. The other had each workerperforming only 1 or a few of the 18 tasks that go into making a complete pin.

In a comparison of the relative performance of these different ways of orga-nizing production, Smith found that the performance of the factories in whichworkers specialized in only one or a few tasks was much greater than the perfor-mance of the factory in which each worker performed all 18 pin-making tasks.In fact, Smith found that 10 workers specializing in a particular task could make48,000 pins a day, whereas those workers who performed all the tasks couldmake only a few thousand at most.4 Smith reasoned that this difference in per-formance was due to the fact that the workers who specialized became muchmore skilled at their specific tasks and as a group were thus able to produce aproduct faster than the group of workers who each performed many tasks.Smith concluded that increasing the level of job specialization—the process bywhich a division of labor occurs as different workers specialize in specific tasksover time—increases efficiency and leads to higher organizational performance.5

Armed with the insights gained from Adam Smith’s observations, other man-agers and researchers began to investigate how to improve job specialization toincrease performance. Management practitioners and theorists focused on howmanagers should organize and control the work process to maximize the advan-tages of job specialization and the division of labor.

44 Chapter Two

job specializationThe process by which adivision of labor occurs asdifferent workers specializein different tasks over time.




F. W. Taylor and ScientificManagementFrederick W. Taylor (1856–1915) is best known for defining thetechniques of scientific management, the systematic study ofrelationships between people and tasks for the purpose ofredesigning the work process to increase efficiency. Taylor wasa manufacturing manager who eventually became a consultantand taught other managers how to apply his scientific manage-ment techniques. Taylor believed that if the amount of timeand effort that each worker expends to produce a unit of out-put (a finished good or service) can be reduced by increasingspecialization and the division of labor, the production processwill become more efficient. According to Taylor, the way to cre-ate the most efficient division of labor could best be determinedby scientific management techniques, rather than intuitive orinformal rule-of-thumb knowledge. Based on his experimentsand observations as a manufacturing manager in a variety ofsettings, he developed four principles to increase efficiency inthe workplace:

• Principle 1: Study the way workers perform their tasks, gather all the informal jobknowledge that workers possess, and experiment with ways of improving how tasksare performed.To discover the most efficient method of performing specific tasks, Taylorstudied in great detail and measured the ways different workers went aboutperforming their tasks. One of the main tools he used was a time-and-motionstudy, which involves the careful timing and recording of the actions taken toperform a particular task. Once Taylor understood the existing method ofperforming a task, he then experimented to increase specialization. He trieddifferent methods of dividing and coordinating the various tasks necessaryto produce a finished product. Usually this meant simplifying jobs and hav-ing each worker perform fewer, more routine tasks, as at the pin factory oron Ford’s car assembly line. Taylor also sought to find ways to improve eachworker’s ability to perform a particular task—for example, by reducing thenumber of motions workers made to complete the task, by changing the lay-out of the work area or the type of tools workers used, or by experimentingwith tools of different sizes.

• Principle 2: Codify the new methods of performing tasks into written rules and stan-dard operating procedures.Once the best method of performing a particular task was determined, Tay-lor specified that it should be recorded so that this procedure could betaught to all workers performing the same task. These new methods furtherstandardized and simplified jobs—essentially making jobs even more rou-tine. In this way efficiency could be increased throughout an organization.

• Principle 3: Carefully select workers who possess skills and abilities that match theneeds of the task, and train them to perform the task according to the established rulesand procedures.To increase specialization, Taylor believed workers had to understand thetasks that were required and be thoroughly trained to perform the tasks at


Frederick W. Taylor, founder of ScientificManagement, and one of the first people to study the behavior and performance ofpeople at work.

scientificmanagement Thesystematic study ofrelationships betweenpeople and tasks for thepurpose of redesigning thework process to increaseefficiency.




46 Chapter Two

the required level. Workers who could not be trained to this level were to betransferred to a job where they were able to reach the minimum requiredlevel of proficiency.6

• Principle 4: Establish a fair or acceptable level of performance for a task, and thendevelop a pay system that provides a reward for performance above the acceptable level.To encourage workers to perform at a high level of efficiency, and to providethem with an incentive to reveal the most efficient techniques for performinga task, Taylor advocated that workers benefit from any gains in performance.They should be paid a bonus and receive some percentage of the perfor-mance gains achieved through the more efficient work process.7

By 1910 Taylor’s system of scientific management had become nationallyknown and in many instances was faithfully and fully practiced.8 However,managers in many organizations chose to implement the new principles of sci-entific management selectively. This decision ultimately resulted in problems.For example, some managers using scientific management obtained increases inperformance, but rather than sharing performance gains with workers throughbonuses as Taylor had advocated, they simply increased the amount of workthat each worker was expected to do. Many workers experiencing the reorga-nized work system found that as their performance increased, managersrequired that they do more work for the same pay. Workers also learned thatincreases in performance often meant fewer jobs and a greater threat of layoffsbecause fewer workers were needed. In addition, the specialized, simplified jobswere often monotonous and repetitive, and many workers became dissatisfiedwith their jobs.

Scientific management brought many workers more hardship than gain anda distrust of managers who did not seem to care about workers’ well-being.9These dissatisfied workers resisted attempts to use the new scientific manage-ment techniques and at times even withheld their job knowledge from man-agers to protect their jobs and pay. It is not difficult for workers to conceal thetrue potential efficiency of a work system to protect their interests. Experiencedmachine operators, for example, can slow their machines in undetectable waysby adjusting the tension in the belts or by misaligning the gears. Workers some-times even develop informal work rules that discourage high performance andencourage shirking as work groups attempt to identify an acceptable or fair per-formance level (a tactic discussed in the next section).

Unable to inspire workers to accept the new scientific management tech-niques for performing tasks, some organizations increased the mechanizationof the work process. For example, one reason why Henry Ford introducedmoving conveyor belts in his factory was the realization that when a conveyorbelt controls the pace of work (instead of workers setting their own pace),workers can be pushed to perform at higher levels—levels that they may havethought were beyond their reach. Charlie Chaplin captured this aspect of massproduction in one of the opening scenes of his famous movie Modern Times(1936). In the film, Chaplin caricatured a new factory employee fighting towork at the machine-imposed pace but losing the battle to the machine. HenryFord also used the principles of scientific management to identify the tasks thateach worker should perform on the production line and thus to determine themost effective way to create a division of labor to suit the needs of a mecha-nized production system.





Charlie Chaplin tries toextricate a fellow employeefrom the machinery ofmass production in thisscene from Modern Times.The complex machinery ismeant to represent thepower that machinery hasover the worker in the newwork system.

From a performance perspective, the combination of the two managementpractices—(1) achieving the right mix of worker-task specialization and (2) link-ing people and tasks by the speed of the production line—makes sense. It pro-duces the huge savings in cost and huge increases in output that occur in large,organized work settings. For example, in 1908 managers at the Franklin MotorCompany using scientific management principles redesigned the work process,and the output of cars increased from 100 cars a month to 45 cars a day; work-ers’ wages, however, increased by only 90 percent.10 From other perspectives,however, scientific management practices raise many concerns. The definitionof workers’ rights, not by the workers themselves, but by the owners or man-agers as a result of the introduction of the new management practices, raised anethical issue, which we examine in the following “Ethics in Action.”

Fordism in PracticeFrom 1908 to 1914, through trial and error, Henry Ford’s talented team of pro-duction managers pioneered the development of the moving conveyor belt andthus changed manufacturing practices forever. Although the technical aspects ofthe move to mass production were a dramatic financial success for Ford and forthe millions of Americans who could now afford cars, for the workers who actu-ally produced the cars many human and social problems resulted.

With simplification of the work process, workers grew to hate the monot-ony of the moving conveyor belt. By 1914 Ford’s car plants were experienc-ing huge employee turnover—often reaching levels as high as 300 or 400 per-cent per year as workers left because they could not handle the work-inducedstress.11 Henry Ford recognized these problems and made an announcement:

Ethics in Action




48 Chapter Two

From that point on, to motivate his workforce, he would reduce the length ofthe workday from nine hours to eight hours, and the company would doublethe basic wage from $2.50 to $5.00 per day. This was a dramatic increase,similar to an announcement today of an overnight doubling of the minimumwage. Ford became an internationally famous figure, and the word Fordismwas coined for his new approach.12

Ford’s apparent generosity, however, was matched by an intense effort tocontrol the resources—both human and material—with which his empire wasbuilt. He employed hundreds of inspectors to check up on employees, bothinside and outside his factories. In the factory supervision was close and confin-ing. Employees were not allowed to leave their places at the production line,and they were not permitted to talk to one another. Their job was to concentratefully on the task at hand. Few employees could adapt to this system, and theydeveloped ways of talking out of the sides of their mouths, like ventriloquists,and invented a form of speech that became known as the “Ford Lisp.”13 Ford’sobsession with control brought him into greater and greater conflict with man-agers, who often were fired when they disagreed with him. As a result, many tal-ented people left Ford to join a growing number of rival car companies.

Outside the workplace, Ford went so far as to establish what he called the“Sociological Department” to check up on how his employees lived and theways they spent their time. Inspectors from this department visited the homesof employees and investigated their habits and problems. Employees whoexhibited behaviors contrary to Ford’s standards (for instance, if they dranktoo much or were always in debt) were likely to be fired. Clearly, Ford’s effortsto control his employees led him and his managers to behave in ways thattoday would be considered unacceptable and unethical and in the long runwould impair an organization’s ability to prosper.

Despite the problems of worker turnover, absenteeism, and discontent atFord Motor Company, managers of the other car companies watched Fordreap huge gains in efficiency from the application of the new managementprinciples. They believed that their companies would have to imitate Ford ifthey were to survive. They followed Taylor and used many of his followers asconsultants to teach them how to adopt the techniques of scientific manage-ment. In addition, Taylor elaborated his principles in several books, includ-ing Shop Management (1903) and The Principles of Scientific Management (1911),which explain in detail how to apply the principles of scientific managementto reorganize the work system.14

Taylor’s work has had an enduring effect on the management of productionsystems. Managers in every organization, whether it produces goods or services,now carefully analyze the basic tasks that must be performed and try to devisethe work systems that allow their organizations to operate most efficiently.

The GilbrethsTwo prominent followers of Taylor were Frank Gilbreth (1868–1924) and Lil-lian Gilbreth (1878–1972), who refined Taylor’s analysis of work movementsand made many contributions to time-and-motion study.15 Their aims were to(1) break up and analyze every individual action necessary to perform a partic-





ular task into each of its componentactions, (2) find better ways to performeach component action, and (3) reor-ganize each of the component actionsso that the action as a whole could beperformed more efficiently—at less costin time and effort.

The Gilbreths often filmed a workerperforming a particular task and thenseparated the task actions, frame byframe, into their component move-ments. Their goal was to maximize theefficiency with which each individualtask was performed so that gains acrosstasks would add up to enormous sav-ings of time and effort. Their attemptsto develop improved managementprinciples were captured—at times quitehumorously—in the movie Cheaper bythe Dozen, a new version of whichappeared in 2004, which depicts howthe Gilbreths (with their 12 children)

tried to live their own lives according to these efficiency principles and applythem to daily actions such as shaving, cooking, and even raising a family.16

Eventually, the Gilbreths became increasingly interested in the study offatigue. They studied how the physical characteristics of the workplace con-tribute to job stress that often leads to fatigue and thus poor performance. Theyisolated factors that result in worker fatigue, such as lighting, heating, the colorof walls, and the design of tools and machines. Their pioneering studies pavedthe way for new advances in management theory.

In workshops and factories, the work of the Gilbreths, Taylor, and many oth-ers had a major effect on the practice of management. In comparison with theold crafts system, jobs in the new system were more repetitive, boring, andmonotonous as a result of the application of scientific management principles,and workers became increasingly dissatisfied. Frequently, the management ofwork settings became a game between workers and managers: Managers triedto initiate work practices to increase performance, and workers tried to hide thetrue potential efficiency of the work setting to protect their own well-being.17

This scene from Cheaper by the Dozen illustrates how “efficient families,”such as the Gilbreths, use formal family courts to solve problems of assigningchores to different family members and to solve disputes when they arise.

Side by side with scientific managers studying the per-son-task mix to increase efficiency, other researcherswere focusing on administrative management, thestudy of how to create an organizational structure thatleads to high efficiency and effectiveness. Organizationalstructure is the system of task and authority relationships

that control how employees use resources to achieve the organization’s goals.Two of the most influential views regarding the creation of efficient systemsof organizational administration were developed in Europe: Max Weber, a

AdministrativeManagement

Theoryadministrativemanagement Thestudy of how to create anorganizational structurethat leads to high efficiencyand effectiveness.




50 Chapter Two

German professor of sociology, developed one theory; Henri Fayol, the Frenchmanager who developed the model of management introduced in Chapter 1,developed the other.

The Theory of BureaucracyMax Weber (1864–1920), wrote at the turn of the 20th century, when Germanywas undergoing its industrial revolution.18 To help Germany manage its growingindustrial enterprises at a time when it was striving to become a world power,Weber developed the principles of bureaucracy—a formal system of organiza-tion and administration designed to ensure efficiency and effectiveness. Abureaucratic system of administration is based on the five principles summa-rized in Figure 2.2.

• Principle 1: In a bureaucracy, a manager’s formal authority derives from the posi-tion he or she holds in the organization.Authority is the power to hold people accountable for their actions and tomake decisions concerning the use of organizational resources. Authoritygives managers the right to direct and control their subordinates’ behaviorto achieve organizational goals. In a bureaucratic system of administration,obedience is owed to a manager, not because of any personal qualities—such as personality, wealth, or social status—but because the manager occu-pies a position that is associated with a certain level of authority andresponsibility.19

• Principle 2: In a bureaucracy, people should occupy positions because of their perfor-mance, not because of their social standing or personal contacts.This principle was not always followed in Weber’s time and is often ignoredtoday. Some organizations and industries are still affected by social networksin which personal contacts and relations, not job-related skills, influence hir-ing and promotional decisions.

• Principle 3: The extent of each position’s formal authority and task responsibilities,and its relationship to other positions in an organization, should be clearly specified.When the tasks and authority associated with various positions in the orga-nization are clearly specified, managers and workers know what is expectedof them and what to expect from each other. Moreover, an organization canhold all its employees strictly accountable for their actions when they knowtheir exact responsibilities.

• Principle 4: Authority can be exercised effectively in an organization when positions arearranged hierarchically, so employees know whom to report to and who reports to them.20

Managers must create an organizational hierarchy of authority that makes itclear who reports to whom and to whom managers and workers should go ifconflicts or problems arise. This principle is especially important in thearmed forces, FBI, CIA, and other organizations that deal with sensitiveissues involving possible major repercussions. It is vital that managers athigh levels of the hierarchy be able to hold subordinates accountable fortheir actions.

• Principle 5: Managers must create a well-defined system of rules, standard operatingprocedures, and norms so that they can effectively control behavior within an organization.

bureaucracy A formalsystem of organization andadministration designed toensure efficiency andeffectiveness.

authority The power tohold people accountablefor their actions and tomake decisions concerningthe use of organizationalresources.




Rules are formal written instructions that specify actions to be taken underdifferent circumstances to achieve specific goals (for example, if A happens,do B). Standard operating procedures (SOPs) are specific sets of writteninstructions about how to perform a certain aspect of a task. A rule mightstate that at the end of the workday employees are to leave their machinesin good order, and a set of SOPs would specify exactly how they should doso, itemizing which machine parts must be oiled or replaced. Norms areunwritten, informal codes of conduct that prescribe how people should actin particular situations. For example, an organizational norm in a restaurantmight be that waiters should help each other if time permits.

Rules, SOPs, and norms provide behavioral guidelines that increase theperformance of a bureaucratic system because they specify the best ways toaccomplish organizational tasks. Companies such as McDonald’s and Wal-Mart have developed extensive rules and procedures to specify the behaviorsrequired of their employees, such as “Always greet the customer with a smile.”

Weber believed that organizations that implement all five principles establish abureaucratic system that improves organizational performance. The specificationof positions and the use of rules and SOPs to regulate how tasks are performedmake it easier for managers to organize and control the work of subordinates.Similarly, fair and equitable selection and promotion systems improve managers’feelings of security, reduce stress, and encourage organizational members to actethically and further promote the interests of the organization.21

If bureaucracies are not managed well, however, many problems can result.Sometimes, managers allow rules and SOPs, “bureaucratic red tape,” to becomeso cumbersome that decision making is slow and inefficient and organizations


Clearly specifiedsystem of task androle relationships.

System of writtenrules and standard

operating proceduresthat specify how

employees should behave.

A bureaucracyshould have a:

Selection andevaluation system

that rewardsemployees fairlyand equitably.

Clearly specifiedhierarchy of

authority.

Figure 2.2Weber’s Principlesof Bureaucracy

rules Formal writteninstructions that specifyactions to be taken underdifferent circumstances toachieve specific goals.

standard operatingprocedures (SOPs)Specific sets of writteninstructions about how toperform a certain aspect ofa task.

norms Unwritten, informalcodes of conduct thatprescribe how peopleshould act in particularsituations.




are unable to change. When managers rely too much on rules to solve problemsand not enough on their own skills and judgment, their behavior becomesinflexible. A key challenge for managers is to use bureaucratic principles to ben-efit, rather than harm, an organization.

Fayol’s Principles of ManagementHenri Fayol (1841–1925), was the CEO of Comambault Mining. Working at thesame time as, but independently from, Weber, Fayol identified 14 principles(summarized in Table 2.1) that he believed essential to increase the efficiency ofthe management process.22 We discuss these principles in detail here because,although they were developed at the turn of the 20th century, they remain thebedrock on which much of recent management theory and research is based. Infact, as the “Management Insight” following this discussion suggests, modernwriters such as well-known management guru Tom Peters continue to extolthese principles.

DIVISION OF LABOR A champion of job specialization and the divisionof labor for reasons already mentioned, Fayol was nevertheless among the firstto point out the downside of too much specialization: boredom—a state of mindlikely to cause a fall in product quality, worker initiative, and flexibility. As aresult, Fayol advocated that workers be given more job duties to perform or beencouraged to assume more responsibility for work outcomes, a principleincreasingly applied today in organizations that empower their workers.

AUTHORITY AND RESPONSIBILITY Like Weber, Fayol emphasizedthe importance of authority and responsibility. Fayol, however, went beyondWeber’s formal authority, which derives from a manager’s position in the hier-archy, to recognize the informal authority that derives from personal expertise,technical knowledge, moral worth, and the ability to lead and to generate com-mitment from subordinates. (The study of authority is the subject of recentresearch into leadership, discussed in Chapter 12.)

UNITY OF COMMAND The principle of unity of command specifies thatan employee should receive orders from, and report to, only one superior. Fayolbelieved that dual command, the reporting relationship that exists when twosupervisors give orders to the same subordinate, should be avoided except inexceptional circumstances. Dual command confuses subordinates, underminesorder and discipline, and creates havoc within the formal hierarchy of authority.Assessing any manager’s authority and responsibility in a system of dual com-mand is difficult, and the manager who is bypassed feels slighted and angry andmay be uncooperative in the future.

LINE OF AUTHORITY The line of authority is the chain of commandextending from the top to the bottom of an organization. Fayol was one of the firstmanagement theorists to point out the importance of limiting the length of thechain of command by controlling the number of levels in the managerial hierar-chy. The greater the number of levels in the hierarchy, the longer communicationbetween managers at the top and bottom takes and the slower the pace of plan-ning and organizing. Restricting the number of hierarchical levels to lessen thesecommunication problems enables an organization to act quickly and flexibly; thisis one reason for the recent trend toward restructuring (discussed in Chapter 1).

52 Chapter Two

unity of command Areporting relationship inwhich an employeereceives orders from, andreports to, only onesuperior.

line of authority Thechain of commandextending from the top tothe bottom of anorganization.




Fayol also pointed out that when organizations are split into different depart-ments or functions, each with its own hierarchy, it is important to allow middleand first-line managers in each department to interact with managers at similarlevels in other departments. This interaction helps to speed decision making,because managers know each other and know whom to go to when problemsarise. For cross-departmental integration to work, Fayol noted the importance ofkeeping one’s superiors informed about what is taking place so that lower-leveldecisions do not harm activities taking place in other parts of the organization.One alternative to cross-departmental integration is to create cross-departmentalteams controlled by a team leader (see Chapter 1).

CENTRALIZATION Fayol also was one of the first management writers tofocus on centralization, the concentration of authority at the top of the managerialhierarchy. Fayol believed that authority should not be concentrated at the top of thechain of command. One of the most significant issues that top managers face is howmuch authority to centralize at the top of the organization and what authority todecentralize to managers and workers at lower hierarchical levels. This is an impor-tant issue because it affects the behavior of people at all levels in the organization.


Table 2.1Fayol’s 14 Principles of Management

Division of Labor Job specialization and the division of labor should increaseefficiency, especially if managers take steps to lessen workers’ boredom.Authority and Responsibility Managers have the right to give orders and thepower to exhort subordinates for obedience.Unity of Command An employee should receive orders from only one superior.Line of Authority The length of the chain of command that extends from thetop to the bottom of an organization should be limited.Centralization Authority should not be concentrated at the top of the chain ofcommand.Unity of Direction The organization should have a single plan of action toguide managers and workers.Equity All organizational members are entitled to be treated with justice andrespect.Order The arrangement of organizational positions should maximizeorganizational efficiency and provide employees with satisfying career opportunities.Initiative Managers should allow employees to be innovative and creative.Discipline Managers need to create a workforce that strives to achieveorganizational goals.Remuneration of Personnel The system that managers use to rewardemployees should be equitable for both employees and the organization.Stability of Tenure of Personnel Long-term employees develop skills thatcan improve organizational efficiency.Subordination of Individual Interests to the Common Interest Employeesshould understand how their performance affects the performance of the wholeorganization.Esprit de Corps Managers should encourage the development of sharedfeelings of comradeship, enthusiasm, or devotion to a common cause.

centralization Theconcentration of authorityat the top of themanagerial hierarchy.




If authority is very centralized, only managers at the top make importantdecisions, and subordinates simply follow orders. This arrangement gives topmanagers great control over organizational activities and helps ensure thatthe organization is pursuing its strategy, but it makes it difficult for the peoplewho are closest to problems and issues to respond to them in a timely man-ner. It also can lower the motivation of middle and first-line managers andmake them less flexible and adaptable because they become reluctant tomake decisions on their own, even when doing so is necessary. They get usedto passing the buck. As we saw in Chapter 1, the pendulum is now swingingtoward decentralization, as organizations seek to empower middle managersand create self-managed teams that monitor and control their own activitiesboth to increase organizational flexibility and to reduce operating costs andincrease efficiency.

UNITY OF DIRECTION Just as there is a need for unity of command,there is also a need for unity of direction, the singleness of purpose that makespossible the creation of one plan of action to guide managers and workers asthey use organizational resources. An organization without a single guiding planbecomes inefficient and ineffective; its activities become unfocused, and indi-viduals and groups work at cross-purposes. Successful planning starts with topmanagers working as a team to craft the organization’s strategy, which theycommunicate to middle managers, who decide how to use organizationalresources to implement the strategy.

EQUITY As Fayol wrote, “For personnel to be encouraged to carry out theirduties with all the devotion and loyalty of which they are capable, they must betreated with respect for their own sense of integrity, and equity results from thecombination of respect and justice.”23 Equity—the justice, impartiality, and fair-ness to which all organizational members are entitled—is receiving much atten-tion today; the desire to treat employees fairly is a primary concern for manymanagers. (Equity theory is discussed in Chapter 12).

ORDER Like Taylor and the Gilbreths, Fayol was interested in analyzing jobs,positions, and individuals to ensure that the organization was using resources asefficiently as possible. To Fayol, order meant the methodical arrangement ofpositions to provide the organization with the greatest benefit and to provideemployees with career opportunities that satisfy their needs. Thus, Fayol recom-mended the use of organizational charts to show the position and duties of eachemployee and to indicate which positions an employee might move to or be pro-moted into in the future. He also advocated that managers engage in extensivecareer planning to help ensure orderly career paths. Career planning is of pri-mary interest today as organizations increase the resources they are willing todevote to training and developing their workforces.

INITIATIVE Although order and equity are important means to fosteringcommitment and loyalty among employees, Fayol believed that managersmust also encourage employees to exercise initiative, the ability to act on theirown, without direction from a superior. Used properly, initiative can be amajor source of strength for an organization because it leads to creativity andinnovation. Managers need skill and tact to achieve the difficult balancebetween the organization’s need for order and employees’ desire for initiative.

54 Chapter Two

unity of direction Thesingleness of purpose thatmakes possible thecreation of one plan ofaction to guide managersand workers as they useorganizational resources.

equity The justice,impartiality, and fairness towhich all organizationalmembers are entitled.

initiative The ability toact on one’s own, withoutdirection from a superior.

order The methodicalarrangement of positionsto provide the organizationwith the greatest benefitand to provide employeeswith career opportunities.




Fayol believed that the ability to strike this balance was a key indicator of asuperior manager.

DISCIPLINE In focusing on the importance of discipline—obedience,energy, application, and other outward marks of respect for a superior’sauthority—Fayol was addressing the concern of many early managers: Howto create a workforce that was reliable and hardworking and would strive toachieve organizational goals. According to Fayol, discipline results in respect-ful relations between organizational members and reflects the quality of anorganization’s leadership and a manager’s ability to act fairly and equitably.

REMUNERATION OF PERSONNEL Fayol proposed reward systemsincluding bonuses and profit-sharing plans, which are increasingly utilizedtoday as organizations seek improved ways to motivate employees. Convincedfrom his own experience that an organization’s payment system has importantimplications for organizational success, Fayol believed that effective reward sys-tems should be equitable for both employees and the organization, encourageproductivity by rewarding well-directed effort, not be subject to abuse, and beuniformly applied to employees.

STABILITY OF TENURE OF PERSONNEL Fayol also recognized theimportance of long-term employment, and the idea has been echoed by con-temporary management gurus such as Tom Peters, Jeff Pfeffer, and WilliamOuchi. When employees stay with an organization for extended periods of time, they develop skills that improve the organization’s ability to utilize itsresources.

SUBORDINATION OF INDIVIDUAL INTERESTS TO THE COMMONINTEREST The interests of the organization as a whole must take prece-dence over the interests of any one individual or group if the organization is tosurvive. Equitable agreements must be established between the organizationand its members to ensure that employees are treated fairly and rewarded fortheir performance and to maintain the disciplined organizational relationshipsso vital to an efficient system of administration.

ESPRIT DE CORPS As this discussion of Fayol’s ideas suggests, the appro-priate design of an organization’s hierarchy of authority and the right mix oforder and discipline foster cooperation and commitment. Likewise, a key ele-ment in a successful organization is the development of esprit de corps, aFrench expression that refers to shared feelings of comradeship, enthusiasm, ordevotion to a common cause among members of a group. Esprit de corps canresult when managers encourage personal, verbal contact between managersand workers and encourage communication to solve problems and implementsolutions. (Today, the term organizational culture is used to refer to these sharedfeelings; this concept is discussed at length in Chapter 3.)

Some of the principles that Fayol outlined have faded from contemporarymanagement practices, but most have endured. The characteristics of organiza-tions that Tom Peters and Robert Waterman identified as being “excellentlymanaged” in their best-selling book In Search of Excellence (1982) are discussed inthe following “Management Insight.”24


discipline Obedience,energy, application, andother outward marks ofrespect for a superior’sauthority.

esprit de corps Sharedfeelings of comradeship,enthusiasm, or devotion toa common cause amongmembers of a group.




56 Chapter Two

Peters and Waterman’s Excellent CompaniesIn the early 1980s, Tom Peters and Robert Waterman identified 62 organiza-tions that they considered to be the best-performing organizations in theUnited States. They asked the question: Why do these companies performbetter than their rivals? and discovered that successful organizations havemanagers who manage according to three sets of related principles. Thoseprinciples have a great deal in common with Fayol’s principles.

First, Peters and Waterman argued, top managers of successful companiescreate principles and guidelines that emphasize managerial autonomy andentrepreneurship and encourage risk taking and initiative. For example, theyallow middle managers to develop new products, even though there is noassurance that these products will be winners. In high-performing organiza-tions, top managers are closely involved in the day-to-day operations of thecompany, provide unity of command and unity of direction, and do not simplymake decisions in an isolated ivory tower. Top managers decentralize authorityto lower-level managers and nonmanagerial employees and give them thefreedom to get involved and the motivation to get things done.

The second approach that managers of excellent organizations use toincrease performance is to create one central plan that puts organizationalgoals at center stage. In high-performing organizations, managers focus atten-tion on what the organization does best, and the emphasis is on continuouslyimproving the goods and services the organization provides to its customers.Managers of top-performing companies resist the temptation to get side-tracked into pursuing ventures outside their area of expertise just becausethey seem to promise a quick return. These managers also focus on cus-tomers and establish close relationships with them to learn their needs, forresponsiveness to customers increases competitive advantage.

The third set of management principles pertains to organizing and control-ling the organization. Excellent companies establish a division of work and adivision of authority and responsibility that will motivate employees to subordinatetheir individual interests to the common interest. Inherent in this approach is thebelief that high performance derives from individual skills and abilities andthat equity, order, initiative, and other indications of respect for the individualcreate the esprit de corps that fosters productive behavior. An emphasis onentrepreneurship and respect for every employee leads the best managers tocreate a structure that gives employees room to exercise initiative and moti-vates them to succeed. Because a simple, streamlined managerial hierarchy isbest suited to achieve this outcome, top managers keep the line of authority asshort as possible. They also decentralize authority to permit employee partic-ipation, but they keep enough control to maintain unity of direction.

ManagementInsight

As this insight into contemporary management suggests, the basic concernsthat motivated Fayol continue to motivate management theorists.25 The princi-ples that Fayol and Weber set forth still provide a clear and appropriate set ofguidelines that managers can use to create a work setting that makes efficient andeffective use of organizational resources. These principles remain the bedrock ofmodern management theory; recent researchers have refined or developed them





Because the writings of Weber and Fayol were not trans-lated into English and published in the United States untilthe late 1940s, American management theorists in the firsthalf of the 20th century were unaware of the contributionsof these European pioneers. American management theo-rists began where Taylor and his followers left off. Although

their writings were all very different, these theorists all espoused a theme thatfocused on behavioral management, the study of how managers should person-ally behave to motivate employees and encourage them to perform at high levelsand be committed to achieving organizational goals.

The Work of Mary Parker FollettIf F. W. Taylor is considered the father of management thought, Mary Parker Fol-lett (1868–1933) serves as its mother.26 Much of her writing about managementand about the way managers should behave toward workers was a response to herconcern that Taylor was ignoring the human side of the organization. She pointedout that management often overlooks the multitude of ways in which employeescan contribute to the organization when managers allow them to participate andexercise initiative in their everyday work lives.27 Taylor, for example, never pro-posed that managers should involve workers in analyzing their jobs to identifybetter ways to perform tasks or should even ask workers how they felt about theirjobs. Instead, he used time-and-motion experts to analyze workers’ jobs for them.Follett, in contrast, argued that because workers know the most about their jobs,

they should be involved in job analysis and managers should allowthem to participate in the work development process.

Follett proposed that “authority should go with knowledge . . .whether it is up the line or down.” In other words, if workers havethe relevant knowledge, then workers, rather than managers, shouldbe in control of the work process itself, and managers should behaveas coaches and facilitators—not as monitors and supervisors. In mak-ing this statement, Follett anticipated the current interest in self-man-aged teams and empowerment. She also recognized the importanceof having managers in different departments communicate directlywith each other to speed decision making. She advocated what shecalled “cross-functioning”: members of different departments work-ing together in cross-departmental teams to accomplish projects—anapproach that is increasingly utilized today.28

Fayol also mentioned expertise and knowledge as importantsources of managers’ authority, but Follett went further. She pro-posed that knowledge and expertise, and not managers’ formalauthority deriving from their position in the hierarchy, shoulddecide who will lead at any particular moment. She believed, as domany management theorists today, that power is fluid and shouldflow to the person who can best help the organization achieve itsgoals. Follett took a horizontal view of power and authority, in

BehavioralManagement

Theorybehavioralmanagement Thestudy of how managersshould behave to motivateemployees and encouragethem to perform at highlevels and be committed to the achievement oforganizational goals.

Mary Parker Follett, an early managementthinker who advocated that “Authorityshould go with knowledge . . . whether it isup the line or down.”

to suit modern conditions. For example, Weber’s and Fayol’s concerns for equityand for establishing appropriate links between performance and reward are cen-tral themes in contemporary theories of motivation and leadership.




contrast to Fayol, who saw the formal line of authority and vertical chain ofcommand as being most essential to effective management. Follett’s behavioralapproach to management was very radical for its time.

The Hawthorne Studies and Human RelationsProbably because of its radical nature, Follett’s work was unappreciated by man-agers and researchers until quite recently. Most continued to follow in the foot-steps of Taylor and the Gilbreths. To increase efficiency, they studied ways toimprove various characteristics of the work setting, such as job specialization orthe kinds of tools workers used. One series of studies was conducted from 1924 to1932 at the Hawthorne Works of the Western Electric Company.29 This research,now known as the Hawthorne studies, began as an attempt to investigate how char-acteristics of the work setting—specifically the level of lighting or illumination—affect worker fatigue and performance. The researchers conducted an experimentin which they systematically measured worker productivity at various levels ofillumination.

The experiment produced some unexpected results. The researchers foundthat regardless of whether they raised or lowered the level of illumination, pro-ductivity increased. In fact, productivity began to fall only when the level of illu-mination dropped to the level of moonlight, a level at which, presumably, work-ers could no longer see well enough to do their work efficiently.

The researchers found these results puzzling and invited a noted Harvard psy-chologist, Elton Mayo, to help them. Mayo proposed another series of experi-ments to solve the mystery. These experiments, known as the relay assembly test

experiments, were designed to investigate theeffects of other aspects of the work contexton job performance, such as the effect of thenumber and length of rest periods and hoursof work on fatigue and monotony.30 Thegoal was to raise productivity.

During a two-year study of a small groupof female workers, the researchers againobserved that productivity increased overtime, but the increases could not be solelyattributed to the effects of changes in thework setting. Gradually, the researchersdiscovered that, to some degree, the resultsthey were obtaining were influenced by thefact that the researchers themselves hadbecome part of the experiment. In otherwords, the presence of the researchers wasaffecting the results because the workersenjoyed receiving attention and being thesubject of study and were willing to co-operate with the researchers to producethe results they believed the researchersdesired.

58 Chapter Two

Workers in a telephone manufacturing plant, in 1931. Around this time,researchers at the Hawthorne Works of the Western Electric Companybegan to study the effects of work setting characteristics—such aslighting and rest periods—on productivity. To their surprise, theydiscovered that workers’ productivity was affected more by the attentionthey received from researchers than by the characteristics of the worksetting—a phenomenon that became known as the Hawthorne Effect.




Subsequently, it was found that many other factors also influence workerbehavior, and it was not clear what was actually influencing the Hawthorneworkers’ behavior. However, this particular effect—which became known as theHawthorne effect—seemed to suggest that workers’ attitudes toward theirmanagers affect the level of workers’ performance. In particular, the significantfinding was that each manager’s personal behavior or leadership approach canaffect performance. This finding led many researchers to turn their attention tomanagerial behavior and leadership. If supervisors could be trained to behavein ways that would elicit cooperative behavior from their subordinates, thenproductivity could be increased. From this view emerged the human relationsmovement, which advocates that supervisors be behaviorally trained tomanage subordinates in ways that elicit their cooperation and increase theirproductivity.

The importance of behavioral or human relations training became evenclearer to its supporters after another series of experiments—the bank wiring roomexperiments. In a study of workers making telephone switching equipment,researchers Elton Mayo and F. J. Roethlisberger discovered that the workers, asa group, had deliberately adopted a norm of output restriction to protect theirjobs. Workers who violated this informal production norm were subjected tosanctions by other group members. Those who violated group performancenorms and performed above the norm were called “ratebusters”; those who per-formed below the norm were called “chiselers.”

The experimenters concluded that both types of workers threatened thegroup as a whole. Ratebusters threatened group members because theyrevealed to managers how fast the work could be done. Chiselers were lookeddown on because they were not doing their share of the work. Work-groupmembers disciplined both ratebusters and chiselers to create a pace of work thatthe workers (not the managers) thought was fair. Thus, a work group’s influenceover output can be as great as the supervisors’ influence. Since the work groupcan influence the behavior of its members, some management theorists arguethat supervisors should be trained to behave in ways that gain the goodwill andcooperation of workers so that supervisors, not workers, control the level ofwork-group performance.

One of the main implications of the Hawthorne studies was that the behaviorof managers and workers in the work setting is as important in explaining thelevel of performance as the technical aspects of the task. Managers must under-stand the workings of the informal organization, the system of behavioralrules and norms that emerge in a group, when they try to manage or changebehavior in organizations. Many studies have found that, as time passes, groupsoften develop elaborate procedures and norms that bond members together,allowing unified action either to cooperate with management to raise perfor-mance or to restrict output and thwart the attainment of organizational goals.31

The Hawthorne studies demonstrated the importance of understanding how thefeelings, thoughts, and behavior of work-group members and managers affectperformance. It was becoming increasingly clear to researchers that understand-ing behavior in organizations is a complex process that is critical to increasingperformance.32 Indeed, the increasing interest in the area of managementknown as organizational behavior, the study of the factors that have animpact on how individuals and groups respond to and act in organizations,dates from these early studies.


Hawthorne effect Thefinding that a manager’sbehavior or leadershipapproach can affectworkers’ level ofperformance.

human relationsmovement Amanagement approachthat advocates the ideathat supervisors shouldreceive behavioral trainingto manage subordinates inways that elicit theircooperation and increasetheir productivity.

informal organizationThe system of behavioralrules and norms thatemerge in a group.

organizationalbehavior The study ofthe factors that have animpact on how individualsand groups respond to andact in organizations.




Theory X and Theory YSeveral studies after World War II revealed how assumptions about workers’ atti-tudes and behavior affect managers’ behavior. Perhaps the most influentialapproach was developed by Douglas McGregor. He proposed two sets of assump-tions about how work attitudes and behaviors not only dominate the way man-agers think but also affect how they behave in organizations. McGregor namedthese two contrasting sets of assumptions Theory X and Theory Y (see Figure 2.3).33

THEORY X According to the assumptions of Theory X, the average worker islazy, dislikes work, and will try to do as little as possible. Moreover, workers havelittle ambition and wish to avoid responsibility. Thus, the manager’s task is to coun-teract workers’ natural tendencies to avoid work. To keep workers’ performance ata high level, the manager must supervise workers closely and control their behav-ior by means of “the carrot and stick”—rewards and punishments.

Managers who accept the assumptions of Theory X design and shape the worksetting to maximize their control over workers’ behaviors and minimize workers’control over the pace of work. These managers believe that workers must be madeto do what is necessary for the success of the organization, and they focus on devel-oping rules, SOPs, and a well-defined system of rewards and punishments to con-trol behavior. They see little point in giving workers autonomy to solve their ownproblems because they think that the workforce neither expects nor desires coop-eration. Theory X managers see their role as closely monitoring workers to ensurethat they contribute to the production process and do not threaten product quality.Henry Ford, who closely supervised and managed his workforce, fits McGregor’sdescription of a manager who holds Theory X assumptions.

THEORY Y In contrast, Theory Y assumes that workers are not inherentlylazy, do not naturally dislike work, and, if given the opportunity, will do what isgood for the organization. According to Theory Y, the characteristics of thework setting determine whether workers consider work to be a source of satis-faction or punishment, and managers do not need to closely control workers’behavior to make them perform at a high level because workers exercise self-control when they are committed to organizational goals. The implication ofTheory Y, according to McGregor, is that “the limits of collaboration in the

60 Chapter Two

The average employee is lazy, dislikes work, and will try to do as little as possible.

To ensure that employees work hard, managers should closely supervise

employees.

Managers should create strict work rules and implement a well-defined system of

rewards and punishments to control employees.

Employees are not inherently lazy. Given the chance, employees will do what is

good for the organization.

To allow employees to work in the organization's interest, managers must

create a work setting that provides opportunities for workers to exercise

initiative and self-direction.

Managers should decentralize authority to employees and make sure employees

have the resources necessary to achieve organizational goals.

THEORY X THEORY YFigure 2.3Theory X versusTheory YSource: D. McGregor, TheHuman Side of Enterprise,1960, McGraw-Hill, reproducedwith permission of the McGraw-Hill Companies, Inc.

Theory X A set ofnegative assumptionsabout workers that lead tothe conclusion that amanager’s task is tosupervise workers closelyand control their behavior.

Theory Y A set ofpositive assumptionsabout workers that lead tothe conclusion that amanager’s task is to createa work setting thatencourages commitmentto organizational goals andprovides opportunities forworkers to be imaginativeand to exercise initiativeand self-direction.




organizational setting are not limits of human nature but of management’s inge-nuity in discovering how to realize the potential represented by its humanresources.”34 It is the manager’s task to create a work setting that encouragescommitment to organizational goals and provides opportunities for workers tobe imaginative and to exercise initiative and self-direction.

When managers design the organizational setting to reflect the assumptionsabout attitudes and behavior suggested by Theory Y, the characteristics of theorganization are quite different from those of an organizational setting based onTheory X. Managers who believe that workers are motivated to help the organi-zation reach its goals can decentralize authority and give more control over thejob to workers, both as individuals and in groups. In this setting, individuals andgroups are still accountable for their activities, but the manager’s role is not tocontrol employees but to provide support and advice, to make sure employeeshave the resources they need to perform their jobs, and to evaluate them ontheir ability to help the organization meet its goals. Henri Fayol’s approach toadministration more closely reflects the assumptions of Theory Y, rather thanTheory X. One company that has always operated with the type of manage-ment philosophy inherent in Theory Y is Hewlett-Packard, the subject of thenext “Manager as a Person.”


Manager asa Person

The Hewlett-Packard WayManagers at the electronics company Hewlett-Packard (HP) consistently putinto practice principles derived from Theory Y. (Go to the company’s Website at www.hp.com for additional information.) Founders William Hewlettand David Packard—Bill and Dave, as they are still known throughout theorganization—established a philosophy of management known as the “HP

Way” that is people-oriented, stresses theimportance of treating every person withconsideration and respect, and offersrecognition for achievements.35

HP’s philosophy rests on a few guid-ing principles. One is a policy of long-term employment. HP goes to greatlengths not to lay off workers. At timeswhen fewer people were needed, ratherthan lay off workers management cutpay and shortened the workday untildemand for HP products picked up.This policy strengthened employees’loyalty to the organization.

The HP Way is based on severalgolden rules about how to treat mem-bers of the organization so that they feelfree to be innovative and creative. HPmanagers believe that every employeeof the company is a member of the HPteam. They emphasize the need toincrease the level of communicationamong employees, believing that hori-zontal communication between peers,

Faced with questions about the company’ssurvival, HP CEO Carly Fiorina was forcedbreak with the tradition of “long-termemployment” and lay off over 40 percent of theworkforce.




not just vertical communication up and down the hierarchy, is essential forcreating a positive climate for innovation.

To promote communication and cooperation between employees at differ-ent levels of the hierarchy, HP encourages informality. Managers and workersare on a first-name basis with each other and with the founders, Bill and Dave.In addition, Bill and Dave pioneered the technique known as “managing bywandering around.” People are expected to wander around learning what oth-ers are doing so that they can tap into opportunities to develop new productsor find new avenues for cooperation. Bill and Dave also pioneered the princi-ple that employees should spend 15 percent of their time working on projectsof their own choosing, and they encouraged employees to take equipment andsupplies home to experiment with them on their own time. HP’s productdesign engineers leave their current work out in the open on their desks sothat anybody can see what they are doing, can learn from it, or can suggestways to improve it. Managers are selected and promoted because of their abil-ity to engender excitement and enthusiasm for innovation in their subordi-nates. HP’s offices have low walls and shared laboratories to facilitate commu-nication and cooperation between managers and workers. In all these ways,HP managers seek to promote each employee’s desire to be innovative andalso to create a team and family atmosphere based on cooperation.36

The results of HP’s practices helped it become one of the leading electron-ics companies in the world. In 2001, however, HP, like most other high-techcompanies, was experiencing major problems because of the collapse of thetelecommunications industry, and the company announced that it was search-ing for ways to reduce costs. At first, its current CEO, Carly Fiorino, in keepingwith the management philosophy and values of the company’s founders,announced that HP would not lay off employees but asked them to acceptlower salaries and unpaid leave to help the company through this rough spot.37

It soon became clear, however, that HP’s very survival was at stake as it battledwith efficient global competitors such as Dell and Canon. To fight back, HPmerged with Compaq, but by 2004 it had been forced to lay off over 40 per-cent of its employees and outsource thousands of jobs abroad in order toremain competitive. Fiorino still believes, however, that HP’s values will sur-vive its crisis and help it become the global leader in the next decade.38

62 Chapter Two

management sciencetheory An approach tomanagement that usesrigorous quantitativetechniques to helpmanagers make maximumuse of organizationalresources.

Management science theory is a contemporary approachto management that focuses on the use of rigorous quantita-tive techniques to help managers make maximum use oforganizational resources to produce goods and services. In

essence, management science theory is a contemporary extension of scientificmanagement, which, as developed by Taylor, also took a quantitative approach tomeasuring the worker-task mix to raise efficiency. There are many branches ofmanagement science, and once again, IT, which is having a significant impact onall kinds of management practices, is affecting the tools managers use to make deci-sions.39 Each branch of management science deals with a specific set of concerns:

• Quantitative management utilizes mathematical techniques—such as linear andnonlinear programming, modeling, simulation, queuing theory, and chaostheory—to help managers decide, for example, how much inventory to holdat different times of the year, where to locate a new factory, and how best to

ManagementScience Theory





invest an organization’s financial capital. IT offers managers new andimproved ways of handling information so that they can make more accu-rate assessments of the situation and better decisions.

• Operations management provides managers with a set of techniques that theycan use to analyze any aspect of an organization’s production system toincrease efficiency. IT, through the Internet and through growing B2B net-works, is transforming the way managers handle the acquisition of inputsand the disposal of finished products.

• Total quality management (TQM) focuses on analyzing an organization’s input,conversion, and output activities to increase product quality.40 Once again,through sophisticated software packages and computer-controlled produc-tion, IT is changing the way managers and employees think about the workprocess and ways of improving it.

• Management information systems (MISs) help managers design systems thatprovide information about events occurring inside the organization as wellas in its external environment—information that is vital for effective decisionmaking. Once again, IT gives managers access to more and better informa-tion and allows more managers at all levels to participate in the decision-making process.

All these subfields of management science, enhanced by sophisticated IT, pro-vide tools and techniques that managers can use to help improve the quality oftheir decision making and increase efficiency and effectiveness. We discuss manyof the important developments in management science theory thoroughly in Part 6of this book. In particular, Chapter 17, “Managing Information Systems and Tech-nologies,” describes the management of information systems and technologies,and Chapter 18, “Operations Management: Managing Quality, Efficiency, andResponsiveness to Customers,” focuses on IT, operations management, and TQM.

An important milestone in the history of managementthought occurred when researchers went beyond the studyof how managers can influence behavior within organiza-tions to consider how managers control the organization’srelationship with its external environment, or organiza-tional environment—the set of forces and conditions that

operate beyond an organization’s boundaries but affect a manager’s ability toacquire and utilize resources. Resources in the organizational environmentinclude the raw materials and skilled people that an organization requires to pro-duce goods and services, as well as the support of groups, including customerswho buy these goods and services and provide the organization with financialresources. One way of determining the relative success of an organization is toconsider how effective its managers are at obtaining scarce and valuableresources.41 The importance of studying the environment became clear after thedevelopment of open-systems theory and contingency theory during the 1960s.

The Open-Systems ViewOne of the most influential views of how an organization is affected by its exter-nal environment was developed by Daniel Katz, Robert Kahn, and JamesThompson in the 1960s.42 These theorists viewed the organization as an

OrganizationalEnvironment

Theoryorganizationalenvironment The set offorces and conditions thatoperate beyond anorganization’s boundariesbut affect a manager’sability to acquire and utilizeresources.




64 Chapter Two

open system—a system that takes in resources from its external environmentand converts or transforms them into goods and services that are sent back tothat environment, where they are bought by customers (see Figure 2.4).

At the input stage an organization acquires resources such as raw materials,money, and skilled workers to produce goods and services. Once the organiza-tion has gathered the necessary resources, conversion begins. At the conversionstage the organization’s workforce, using appropriate tools, techniques, andmachinery, transforms the inputs into outputs of finished goods and servicessuch as cars, hamburgers, or flights to Hawaii. At the output stage the organiza-tion releases finished goods and services to its external environment, where cus-tomers purchase and use them to satisfy their needs. The money the organiza-tion obtains from the sales of its outputs allows the organization to acquire moreresources so that the cycle can begin again.

The system just described is said to be open because the organization drawsfrom and interacts with the external environment in order to survive; in otherwords, the organization is open to its environment. A closed system, in con-trast, is a self-contained system that is not affected by changes in its externalenvironment. Organizations that operate as closed systems, that ignore theexternal environment, and that fail to acquire inputs are likely to experienceentropy, the tendency of a closed system to lose its ability to control itself andthus to dissolve and disintegrate.

Management theorists can model the activities of most organizations byusing the open-systems view. Manufacturing companies like Ford and GeneralElectric, for example, buy inputs such as component parts, skilled and semi-skilled labor, and robots and computer-controlled manufacturing equipment;then at the conversion stage they use their manufacturing skills to assembleinputs into outputs of cars and appliances. As we discuss in later chapters, com-petition between organizations for resources is one of several major challengesto managing the organizational environment.

Sales of outputs allow organization

to obtain new supplies of inputs

ENVIRONMENT

• Raw materials• Money and capital• Human resources

Inputstage

Organizationobtains inputs

from itsenvironment

• Machinery• Computers• Human skills

Conversionstage

Organizationtransforms inputsand adds value

to them

• Goods• Services

Outputstage

Organizationreleases

outputs toits environment

Figure 2.4The Organizationas an Open System

closed system Asystem that is self-contained and thus notaffected by changesoccurring in its externalenvironment.

entropy The tendency ofa closed system to lose itsability to control itself andthus to dissolve anddisintegrate.

open system A systemthat takes in resourcesfrom its externalenvironment and convertsthem into goods andservices that are then sentback to that environmentfor purchase by customers.




Researchers using the open-systems view are also interested in how the vari-ous parts of a system work together to promote efficiency and effectiveness. Sys-tems theorists like to argue that the whole is greater than the sum of its parts;they mean that an organization performs at a higher level when its departmentswork together rather than separately. Synergy, the performance gains thatresult from the combined actions of individuals and departments, is possible onlyin an organized system. The recent interest in using teams combined or com-posed of people from different departments reflects systems theorists’ interest indesigning organizational systems to create synergy and thus increase efficiencyand effectiveness.

Contingency TheoryAnother milestone in management theory was the development of contingencytheory in the 1960s by Tom Burns and G. M. Stalker in Britain and PaulLawrence and Jay Lorsch in the United States.43 The crucial message of contin-gency theory is that there is no one best way to organize: The organizational struc-tures and the control systems that managers choose depend on—are contingenton—characteristics of the external environment in which the organization oper-ates. According to contingency theory, the characteristics of the environmentaffect an organization’s ability to obtain resources; and to maximize the like-lihood of gaining access to resources, managers must allow an organization’sdepartments to organize and control their activities in ways most likely to allowthem to obtain resources, given the constraints of the particular environmentthey face. In other words, how managers design the organizational hierarchy,choose a control system, and lead and motivate their employees is contingent onthe characteristics of the organizational environment (see Figure 2.5).

An important characteristic of the external environment that affects an orga-nization’s ability to obtain resources is the degree to which the environment ischanging. Changes in the organizational environment include changes in tech-nology, which can lead to the creation of new products (such as compact discs)and result in the obsolescence of existing products (eight-track tapes); the entryof new competitors (such as foreign organizations that compete for availableresources); and unstable economic conditions. In general, the more quickly theorganizational environment is changing, the greater are the problems associated


synergy Performancegains that result whenindividuals anddepartments coordinatetheir actions.

contingency theoryThe idea that theorganizational structuresand control systemsmanagers choose dependon—are contingent on—characteristics of theexternal environment inwhich the organizationoperates.

Organizations in changing environments choose an organic structure (decentralized authority, horizontal communication flows, cross-departmental cooperation)

Determine the design of an organization's structure and control

systems

Characteristics of the environment

There is no one best way to organize; organizational structure depends on the environment in which an organization operates.

Organizations in stableenvironments choose a

mechanistic structure (centralizedauthority, vertical communicationflows, control through strict rules

and procedures)

Figure 2.5Contingency Theoryof OrganizationalDesign




with gaining access to resources and the greater is managers’ need to find waysto coordinate the activities of people in different departments to respond to theenvironment quickly and effectively.

MECHANISTIC AND ORGANIC STRUCTURES Drawing on Weber’sand Fayol’s principles of organization and management, Burns and Stalker pro-posed two basic ways in which managers can organize and control an organiza-tion’s activities to respond to characteristics of its external environment: Theycan use a mechanistic structure or an organic structure.44 As you will see, a mecha-nistic structure typically rests on Theory X assumptions, and an organic struc-ture typically rests on Theory Y assumptions.

When the environment surrounding an organization is stable, managers tendto choose a mechanistic structure to organize and control activities and makeemployee behavior predictable. In a mechanistic structure, authority is central-ized at the top of the managerial hierarchy, and the vertical hierarchy of author-ity is the main means used to control subordinates’ behavior. Tasks and roles areclearly specified, subordinates are closely supervised, and the emphasis is onstrict discipline and order. Everyone knows his or her place, and there is a placefor everyone. A mechanistic structure provides the most efficient way to operatein a stable environment because it allows managers to obtain inputs at the lowestcost, giving an organization the most control over its conversion processes andenabling the most efficient production of goods and services with the smallestexpenditure of resources. McDonald’s restaurants operate with a mechanisticstructure. Supervisors make all important decisions; employees are closely super-vised and follow well-defined rules and standard operating procedures.

In contrast, when the environment is changing rapidly, it is difficult to obtainaccess to resources, and managers need to organize their activities in a way thatallows them to cooperate, to act quickly to acquire resources (such as new types ofinputs to produce new kinds of products), and to respond effectively to the unex-pected. In an organic structure, authority is decentralized to middle and first-linemanagers to encourage them to take responsibility and act quickly to pursuescarce resources. Departments are encouraged to take a cross-departmental orfunctional perspective, and, as in Mary Parker Follett’s model, authority rests withthe individuals and departments best positioned to control the current problemsthe organization is facing. In an organic structure, control is much looser than it isin a mechanistic structure, and reliance on shared norms to guide organizationalactivities is greater. Managers in an organic structure can react more quickly to achanging environment than can managers in a mechanistic structure. However,an organic structure is generally more expensive to operate because it requiresthat more managerial time, money, and effort be spent on coordination. So it isused only when needed—when the organizational environment is unstable andrapidly changing.

66 Chapter Two

mechanistic structureAn organizational structurein which authority iscentralized, tasks and rulesare clearly specified, andemployees are closelysupervised.

In this chapter we examined the evolution of managementtheory and research over the last century. Much of thematerial in the rest of this book stems from developmentsand refinements of this work.

SCIENTIFIC MANAGEMENT THEORY The search for efficiency startedwith the study of how managers could improve person-task relationships toincrease efficiency. The concept of job specialization and division of labor

Summary andReview

organic structure Anorganizational structure inwhich authority isdecentralized to middleand first-line managersand tasks and roles areleft ambiguous toencourage employees tocooperate and respondquickly to the unexpected.




remains the basis for the design of work settings in modern organizations. Newdevelopments such as lean production and total quality management are oftenviewed as advances on the early scientific management principles developed byTaylor and the Gilbreths.

ADMINISTRATIVE MANAGEMENT THEORY Max Weber and HenriFayol outlined principles of bureaucracy and administration that are as relevantto managers today as they were when developed at the turn of the 20th century.Much of modern management research refines these principles to suit contem-porary conditions. For example, the increasing interest in the use of cross-departmental teams and the empowerment of workers are issues that managersalso faced a century ago.

BEHAVIORAL MANAGEMENT THEORY Researchers have describedmany different approaches to managerial behavior, including Theories X and Y.Often, the managerial behavior that researchers suggest reflects the context oftheir own historical era and culture. Mary Parker Follett advocated managerialbehaviors that did not reflect accepted modes of managerial behavior at thetime, and her work was largely ignored until conditions changed.

MANAGEMENT SCIENCE THEORY The various branches of manage-ment science theory provide rigorous quantitative techniques that give man-agers more control over each organization’s use of resources to produce goodsand services.

ORGANIZATIONAL ENVIRONMENT THEORY The importance ofstudying the organization’s external environment became clear after the devel-opment of open-systems theory and contingency theory during the 1960s. Amain focus of contemporary management research is to find methods to helpmanagers improve the ways they utilize organizational resources and competesuccessfully in the global environment. Strategic management and total qualitymanagement are two important approaches intended to help managers makebetter use of organizational resources.





Discussion1. Choose a fast-food restaurant,

a department store, or someother organization with whichyou are familiar, and describethe division of labor and jobspecialization it uses toproduce goods and services.How might this division oflabor be improved?

2. Apply Taylor’s principles ofscientific management toimprove the performance ofthe organization you chose initem 1.

3. In what ways are Weber’sand Fayol’s ideas about

bureaucracy andadministration similar? In what ways do they differ?

4. Which of Weber’s and Fayol’sprinciples seem most relevantto the creation of an ethicalorganization?

5. Why was the work of MaryParker Follett ahead of itstime? To what degree do youthink it is appropriate today?

6. What is contingency theory?What kinds of organizationsfamiliar to you have beensuccessful or unsuccessful indealing with contingenciesfrom the external environment?

Imagine that you are the foundingentrepreneur of a software com-

pany that specializes in developinggames for home computers. Cus-tomer demand for your games hasincreased so much that over thelast year your company has grownfrom a busy 1-person operation toone with 16 employees. In additionto yourself, you employ six soft-ware developers to produce thesoftware, three graphic artists, twocomputer technicians, two market-ing and sales personnel, and twosecretaries. In the next year you

expect to hire 30 new employees,and you are wondering how best tomanage your growing company.1. Use the principles of Weber

and Fayol to decide on thesystem of organization andmanagement that you thinkwill be most effective for yourgrowing organization. Howmany levels will themanagerial hierarchy of yourorganization have? How muchauthority will you decentralizeto your subordinates? How willyou establish the division of

labor between subordinates?Will your subordinates workalone and report to you orwork in teams?

2. Which management approach(for example, Theory X or Y)do you propose to use to runyour organization? In 50words or less write astatement describing themanagement approach youbelieve will motivate andcoordinate your subordinates,and tell why you think thisstyle will be best.

Management in Action

Topics for Discussion and Action

68

Building Management SkillsManaging Your Own Business

Now that you understand the concerns addressed by management thinkers over the lastcentury, use this exercise to apply your knowledge to developing your management skills.

7. Why are mechanistic andorganic structures suited todifferent organizationalenvironments?

Action8. Question a manager about his

or her views of the relativeimportance of Fayol’s 14principles of management.

9. Visit at least two organizationsin your community, andidentify those that seem tooperate with a Theory X or a Theory Y approach tomanagement.




Control is one of Ron Edens’sfavorite words. “This is a con-

trolled environment,” he says of theblank brick building that houses hiscompany, Electronic Banking Sys-tem Inc.

Inside, long lines of women sit atspartan desks, slitting envelopes,sorting contents and filling out “con-trol cards” that record how manyletters they have opened and howlong it has taken them. Workershere, in “the cage,” must processthree envelopes a minute. Nearby,other women tap keyboards, keep-ing pace with a quota that demands8,500 strokes an hour.

The room is silent. Talking is for-bidden. The windows are covered.Coffee mugs, religious pictures andother adornments are barred fromworkers’ desks.

In his office upstairs, Mr. Edenssits before a TV monitor that flashesimages from eight cameras postedthrough the plant. “There’s a little bitof Sneaky Pete to it,” he says, usinga remote control to zoom in on adocument atop a worker’s desk. “Ican basically read that and figureout how someone’s day is going.”

This day, like most others, isgoing smoothly, and Mr. Edens’sbusiness has boomed as a result.“We maintain a lot of control,” hesays. “Order and control are every-thing in this business.”

Mr. Edens’s business belongs toa small but expanding financial ser-vice known as “lockbox processing.”Many companies and charities thatonce did their paperwork in-housenow “out-source” clerical tasks tofirms like EBS, which processesdonations to groups such as Moth-ers Against Drunk Driving, the DorisDay Animal League, Greenpeace

and the National Organization forWomen.

More broadly, EBS reflects theexplosive growth of jobs in whichworkers perform low-wage and lim-ited tasks in white-collar settings.This has transformed towns likeHagerstown—a blue-collar commu-nity hit hard by industrial layoffs inthe 1970s—into sites for thousandsof jobs in factory-sized offices.

Many of these jobs, though,are part time and most pay farless than the manufacturing occu-pations they replaced. Someworkers at EBS start at the mini-mum wage of $4.25 an hour andmost earn about $6 an hour. Thegrowth of such jobs—which oftencluster outside major cities—alsocompletes a curious historic circle.During the Industrial Revolution,farmers’ daughters went to work in textile towns like Lowell, Mass.In post-industrial America, manywomen of modest means and skillsare entering clerical mills wherethey process paper instead of cloth(coincidentally, EBS occupies a for-mer garment factory).

“The office of the future can looka lot like the factory of the past,”says Barbara Garson, author ofThe Electronic Sweatshop andother books on the modern work-place. “Modern tools are being usedto bring 19th-century working con-ditions into the white-collar world.”

The time-motion philosophies ofFrederick Taylor, for instance, havefound a 1990s correlate in thephone, computer and camera, whichcan be used to monitor workersmore closely than a foreman with astopwatch ever could. Also, thenature of the work often justifies avigilant eye. In EBS workers handle

thousands of dollars in checks andcash, and Mr. Edens says camerashelp deter would-be thieves. Tightsecurity also reassures visitingclients. “If you’re disorderly, they’llthink we’re out of control and thatthings could get lost,” says Mr.Edens, who worked as a financialcontroller for the National Rifle Asso-ciation before founding EBS in 1983.

But tight observation also helpsEBS monitor productivity and weedout workers who don’t keep up.“There’s multiple uses,” Mr. Edenssays of surveillance. His desk iscovered with computer printoutsrecording the precise toll of key-strokes tapped by each data-entryworker. He also keeps a day-to-daytally of errors. The work floor itselfresembles an enormous classroomin the throes of exam period. Deskspoint toward the front, where amanager keeps watch from araised platform that workers call“the pedestal” or “the birdhouse.”Other supervisors are positionedtoward the back of the room. “If youwant to watch someone,” Mr. Edensexplains, “it’s easier from behindbecause they don’t know you’rewatching.” There also is a blackglobe hanging from the ceiling, inwhich cameras are positioned.

Mr. Edens sees nothing Orwellianabout this omniscience. “It’s not aBig Brother attitude,” he says. “It’smore of a calming attitude.”

But studies of workplace moni-toring suggest otherwise. Expertssay that surveillance can create a hostile environment in whichworkers feel pressured, paranoidand prone to stress-related ill-ness. Surveillance also can beused punitively, to intimidate work-ers or to justify their firing.

69

Managing EthicallyMr. Edens Profits from Watching His Workers’ Every Move

Read the case below, “Mr. Edens Profits from Watching His Workers’ Every Move,” and thinkabout the following issues.




Following a failed union drive atEBS, the National Labor RelationsBoard filed a series of complaintsagainst the company, includingcharges that EBS threatened, inter-rogated, and spied on workers. Aspart of an out-of-court settlement,EBS reinstated a fired worker andposted a notice that it would refrainfrom illegal practices during a sec-ond union vote, which also failed.

“It’s all noise,” Mr. Edens says ofthe unfair labor charges. As to thepressure that surveillance creates,Mr. Edens sees that simply as “thenature of the beast.” He adds: “It’sgot to add stress when everyoneknows their production is beingmonitored. I don’t apologize for that.”

Mr. Edens also is unapologeticabout the Draconian work rules hemaintains, including one that for-bids all talk unrelated to the com-pletion of each task. “I’m not payingpeople to chat. I’m paying them toopen envelopes,” he says. Of theblocked windows. Mr. Edens adds:“I don’t want them looking out—it’sdistracting. They’ll make mistakes.”

This total focus boosts productiv-ity but it makes many workers feellonely and trapped. Some try to cir-cumvent the silence rule, like kids ina school library. “If you don’t turnyour head and sort of mumble out ofthe side of your mouth, supervisorswon’t hear you most of the time,”Cindy Kesselring explains duringher lunch break. Even so, she feelsisolated and often longs for her for-mer job as a waitress. “Work is yoursocial life, particularly if you’ve gotkids,” says the 27-year-old mother.“Here it’s hard to get to know peoplebecause you can’t talk.”

During lunch, workers crowd inthe parking lot outside, chattingnonstop. “Some of us don’t eatmuch because the more you chewthe less you can talk,” Ms. Kessel-ring says. There aren’t other breaksand workers aren’t allowed to sipcoffee or eat at their desks during

the long stretches before and afterlunch. Hard candy is the only per-mitted desk snack.

New technology, and the break-ing down of labor into discrete,repetitive tasks, also have effec-tively stripped jobs such as thoseat EBS of whatever variety andskills clerical work once pos-sessed. Workers in the cage (anantiquated banking term for amoney-handling area) only openenvelopes and sort contents; thosein the audit department computefigures; and data-entry clerkspunch in the information that theothers have collected. If they makea mistake, the computer buzzesand a message such as “checkdigit error” flashes on the screen.

“We don’t ask these people tothink—the machines think for them,”Mr. Edens says. “They don’t have tomake any decisions.” This makes thework simpler but also deepens itsmonotony. In the cage, Carol Smithsays she looks forward to envelopesthat contain anything out of the ordi-nary, such as letters reporting thatthe donor is deceased. Or she playsmental games. “I think to myself, Agoes in this pile, B goes here and Cgoes there—sort of like Bingo.” Shesays she sometimes feels “like amachine,” particularly when she fillsout the “control card” on which shelists “time in” and “time out” for eachtray of envelopes. In a slot marked“cage operator” Ms. Smith writes hercode number, 3173. “That’s me,” shesays.

Barbara Ann Wiles, a keyboardoperator, also plays mind games tobreak up the boredom. Tapping inthe names and addresses of newdonors, she tries to imagine thefaces behind the names, particularlythe odd ones. “Like this one, Mrs. Fit-tizzi,” she chuckles. “I can picture heras a very stout lady with a strongaccent, hollering on a street corner.”She picks out another: “Doris Angel-roth—she’s very sophisticated, a

monocle maybe, drinking tea on anoverstuffed mohair couch.”

It is a world remote from the oneMs. Wiles inhabits. Like most EBSemployees, she must juggle herlow-paying job with child care. Onthis Friday, for instance, Ms. Wileswill finish her eight-hour shift atabout 4 P.M., go home for a fewhours, then return for a secondshift from midnight to 8 A.M. Other-wise, she would have to come in onSaturday to finish the week’s work.

This way I can be home on theweekend to look after my kids,”she says.

Others find the work harder toleave behind at the end of the day.In the cage, Ms. Smith says herhusband used to complain becauseshe often woke him in the middle ofthe night. “I’d be shuffling my handsin my sleep,” she says, mimickingthe motion of opening envelopes.

Her cage colleague, Ms. Kessel-ring, says her fiancé has a differentgripe. “He dodges me for a coupleof hours after work because I don’tshut up—I need to talk, talk, talk,”she says. And there is one house-hold task she can no longer abide.

“I won’t pay bills because I can’tstand to open another envelope,”she says. “I’ll leave letters sitting inthe mailbox for days.”

Questions1. Which of the management

theories described in thechapter does Ron Edensmake most use of?

2. What do you think are theeffects of this approach on (a)workers and (b) supervisors?

3. Do you regard Ron Eden’sapproach to management asethical and acceptable orunethical and unacceptable inthe 2000s? Why?

Source: Tony Horwitz, “Mr. Edens Profitsfrom Watching His Workers’ Every Move,”The Wall Street Journal, December 1, 1994.

70




Think of an organization withwhich you are all familiar, such

as a local restaurant, store, or bank.After choosing an organization,

model it from an open-systemsperspective. Identify its input, con-version, and output processes;and identify forces in the external

environment that help or hurt theorganization’s ability to obtain re-sources and dispose of its goodsor services.

Research Ford’s Web site(www.ford.com), and locate

and read the material on Ford’s his-tory and evolution over time. What

have been the significant stages inthe company’s development? Whatproblems and issues confronted

You have been called in toadvise the owners of an exclu-

sive new luxury hotel. For the ven-ture to succeed, hotel employeesmust focus on providing customerswith the highest-quality customerservice possible. The challenge isto devise a way of organizing and

controlling employees that will pro-mote high-quality service, that willencourage employees to be com-mitted to the hotel, and that willreduce the level of employee turn-over and absenteeism—which aretypically high in the hotel business.

Additional Activities on the Build YourManagement Skills DVD• Test Your Knowledge:

Management’s HistoricalFigures

71

Small Group Breakout ExerciseModeling an Open System

Form groups of three to five people, and appoint one group member as the spokespersonwho will communicate your findings to the class when called on by the instructor. Thendiscuss the following scenario.

Exploring the World Wide Webmanagers at these stages? Whatare the challenges facing Ford’smanagers now?

Be the ManagerHow to Manage a Hotel

Questions1. How do the various theories of

management discussed in thischapter offer clues fororganizing and controllinghotel employees?

2. Which parts would be themost important for an effectivesystem to organize andcontrol employees?




Case in the NewsWhat You Don’tKnow About Dell

Dell is the master at sellingdirect, bypassing middlemen to

deliver PCs cheaper than any of itsrivals. And few would quarrel that it’sthe model of efficiency, with a far-flung supply chain knitted togetherso tightly that it’s like one electricalwire, humming 24/7. Yet all this hasbeen true for more than a decade.And although the entire computerindustry has tried to replicate Dell’stactics, none can hold a candle tothe company’s results.

As it turns out, it’s how MichaelDell manages the company thathas elevated it far above its sell-direct business model. What’sDell’s secret? At its heart is hisbelief that the status quo is nevergood enough, even if it meanspainful changes for the man withhis name on the door. When suc-cess is achieved, it’s greeted withfive seconds of praise followed byfive hours of postmortem on whatcould have been done better. SaysMichael Dell: “Celebrate for ananosecond. Then move on.” Afterthe outfit opened its first Asian fac-tory, in Malaysia, the CEO sent themanager heading the job one ofhis old running shoes to congratu-late him. The message: This is onlythe first step in a marathon.

Just as crucial is Michael Dell’sbelief that once a problem is uncov-ered, it should be dealt with quicklyand directly, without excuses.“There’s no ‘The dog ate my home-work’ here,” says Dell. No, indeedy.After Randall D. Groves, then headof the server business, delivered 16percent higher sales last year, hewas demoted. Never mind that noneof its rivals came close to that. It

could have been better, say two for-mer Dell executives. Groves referredcalls to a Dell spokesman, who saysGroves’s job change was part of abroader reorganization.

Above all, Michael Dell expectseveryone to watch each dime—and turn it into at least a quarter.Unlike most tech bosses, Dellbelieves every product should beprofitable from Day One. To ensurethat, he expects his managers tobe walking databases, able tocough up information on every-thing from top-line growth to theaverage number of times a parthas to be replaced in the first 30days after a computer is sold.

But there’s one number he caresabout most: operating margin. ToDell, it’s not enough to rack up prof-its or grow fast. Execs must do bothto maximize long-term profitability.That means products need to bepriced low enough to induce shop-pers to buy, but not so low that theycut unnecessarily into profits. WhenDell’s top managers in Europe lostout on profits in 1999 because theyhadn’t cut costs far enough, theywere replaced. “There are someorganizations where people thinkthey’re a hero if they invent a newthing,” says Rollins. “Being a hero atDell means saving money.”

It’s this combination—reachingfor the heights of perfection whileburrowing down into every last datapoint—that no rival has been ableto imitate. “It’s like watching MichaelJordan stuff the basketball,” saysMerrill Lynch & Co. technologystrategist Steven Milunovich. “I seeit. I understand it. But I can’t do it.”

How did this Mike come by hismanagement philosophy? It started19 years ago, when he was ditchingclasses to sell homemade PCs out

of his University of Texas dormroom. Dell was the scrappy under-dog, fighting for his company’s lifeagainst the likes of IBM and Com-paq Computer Corp. with a direct-sales model that people thought wasplain nuts. Now, Michael Dell isworth $17 billion, while his 40,000-employee company is about to top$40 billion in sales.Yet he continuesto manage Dell with the urgency anddetermination of a college kid withhis back to the wall. “I still think of usas a challenger,” he says. “I still thinkof us attacking.”

All this has kept Dell on track asrivals have gone off the rails. Since2000, the company has beenadding market share at a fasterpace than at any time in its history—nearly three percentage points in2002. A renewed effort to controlcosts sliced overhead expenses tojust 9.6 percent of revenue in themost recent quarter and boostedproductivity to nearly $1 million inrevenue per employee. That’s threetimes the revenue per employee at IBM and almost twice Hewlett-Packard Co.’s rate.

Still, for the restless MichaelDell, that’s not nearly enough. Hewants to make sure the companyhe has spent half his life buildingcan endure after he’s gone. So heand Rollins have sketched out anambitious financial target: $60 bil-lion in revenues by 2006. That’stwice what the company did in 2001and enough to put it in league withthe largest, most powerful compa-nies in the world. Getting there willrequire the same kind of successthat the company achieved inPCs—but in altogether new mar-kets. Already, Michael Dell is mov-ing the company into printers, net-working, handheld computers, and

72




tech services. His latest foray: Dellis entering the cutthroat $95 billionconsumer-electronics market with a portable digital-music player, anonline music store, and a flat-paneltelevision set slated to go on sale inOctober 2004.

Dell also faces an innovationdilemma. Its penny-pinching waysleave little room for investments inproduct development and futuretechnologies, especially comparedwith rivals. Even in the midst of therecession, IBM spent $4.75 billionor 5.9 percent of its revenues, onresearch and development in 2002,while HP ponied up $3.3 billion, or4.8 percent of revenues. And Dell?Just a paltry $455 million, or 1.3percent. Rivals say that handicapsDell’s ability to move much beyondPCs, particularly in such promisingmarkets as digital imaging and util-

ity computing. “Dell is a great com-pany, but they are a one-trick pony,”says HP CEO Carleton S. Fiorina.What’s more, Dell has shown littlepatience for the costs of enteringnew markets, killing off products—like its high-end server—when theydidn’t produce quick profits, ratherthan staying committed to a long-term investment. “They’re the bestin the world at what they do,” saysIBM server chief William M. Zeitler.“The question is, will they be bestat the Next Big Thing?”

Dell’s track record suggests theCEO will meet his $60 billion rev-enue goal by 2006. Already, Dell hasgrabbed large chunks of the marketsfor inexpensive servers and data-storage gear. After just two quarters,its first handheld computer has cap-tured 37 percent of the U.S. marketfor such devices. And Rollins says

initial sales of Dell printers are dou-ble its internal targets. With thepotential growth in PCs and newmarkets, few analysts doubt that Dellcan generate the 15 percent annualgrowth needed to reach the mark.

Questions1. What are the main principles

behind Michael Dell’sapproach to managing?

2. List these principles thencompare them to thosedeveloped by Henry Fayol.In what ways are they similaror different?

Source: Andrew Park and Peter Burrows,“What You Don’t Know About Dell.” Reprintedfrom the November 3, 2003, issue ofBusinessWeek Online by special permission.© 2003 McGraw-Hill Companies, Inc.

73

Cohen: Effective Behavior in Organizations, Seventh Edition

11. Leadership: Exerting Influence and Power

Text 35© The McGraw−Hill Companies, 2002

LeadershipExerting Influence and Power

“The core

problem for

leaders is

getting others

to do what is

necessary to

accomplish the

organization’s

goals.”

MANAGERIAL BULLETIN

The Power of Personal Commitment and Vulnerability

So how do you motivate people? Not with techniques, but by risking yourself with apersonal, lifelong commitment to greatness—by demonstrating courage. You don’tteach it so much as challenge it into existence.

SOURCE: Peter Koestenbaum, Philosopher and Consultant to Top Executives, quoted in Polly Labarre, “Do YouHave the Will to Lead,” Fast Company, March 2000, p. 222.

Chapter

11



Text36 © The McGraw−Hill Companies, 2002

The topic of leadership has fascinated people through the ages. After much discus-sion and research, the pursuit of a universal definition of effective leadership is stillintriguing but elusive. The world awaits definitive answers to such questions as:What makes a good leader? Who can be a leader? Can anyone be a leader? Canleadership skills be taught? What makes followers follow? What are the limits toleadership?

Social science researchers for years pursued the notion that there must be somecommon qualities shared by all leaders. Many long lists of sterling qualities (aggres-siveness, wisdom, charisma, courage, and so forth) have been generated but have notbeen found to apply to all leaders in all situations. To be effective a leader’s qualitiesmust relate somehow to the situation he or she is in and to the nature of the fol-lowers. This view is consistent with the situational approach taken throughout thisbook, yet is barely widely accepted. The belief does not easily fade away that Gen-eral Patton, Mahatma Gandhi, Vince Lombardi, Golda Meir, and Martin LutherKing—or the heads of AOL, GM, Microsoft, and John Hancock—must have had ex-actly the same qualities.

Throughout this and the next chapter, we will be using the terms manager andleader interchangeably, even though customarily there is a distinction. A manager isusually considered to be someone who makes sure that work is carried out properly,while a leader is considered to be the person who decides on what the work oughtto be (i.e., the direction to be taken). The two roles are increasingly hard to separate,since most managers today do have some responsibility for setting direction, andfew get to just carry out routine work.

As you might expect, insofar as there are common components to the manager’sor leader’s job, a few traits appear to be consistent requirements. In Chapter 1 we in-duced from Mintzberg’s analysis of a manager’s job some of the skills required by amanager. Recall that a manager needs interpersonal skills to acquire informationneeded for decision making. Leaders need to have the ability to influence other peo-ple’s behavior, a readiness to absorb interpersonal stress, the capacity to structure so-cial interactions to task needs, some self-confidence, and the drive to exerciseinitiative in social situations, all of which are directly related to the nature of mana-gerial work.

The role of the CEO is to produce poetry and plumbing.

James March

Effective leaders also have a strong drive for responsibility and task completion,energy and persistence for accomplishing goals yet a willingness to tolerate frustra-tion and delay (since working with and through others does not always result in im-mediate action!), some willingness to take risks and be original in solving problems,and, perhaps most important, a willingness to accept the consequences of makingdecisions and taking action.1

In general, you can see that these traits are closely related to the kinds of situa-tions in which virtually all leaders find themselves, having to build relationships inorder to accomplish tasks and having to take responsibility for their system’sperformance.

The particular requirements for effective leadership in each situation, however,may well outweigh all of these traits or make only certain ones critical in impor-tance. As we will show in Chapter 12, different kinds of tasks, different kinds of sub-ordinates, and differing leader characteristics all affect what leader behavior will beeffective. Thus, possession of the qualities listed does not guarantee that one will be-come a leader, nor does the absence of any one of them rule out the possibility of

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LEADERSHIP: EXERTING INFLUENCE AND POWER 253

becoming an effective leader. We, therefore, must emphasize that the potential forleadership may be assumed to be widely distributed among the general population,and a wide variety of leader behaviors may be effective in particular situations.2

What, then, must be taken into account by leaders who wish to be effective intheir particular organization? What behavior works best under what conditions?

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In the Lead: Some Managers Are More than Bosses—They’re Leaders, Too

Managers “know how to write business plans, whileleaders get companies—and people—to change,” saysCarol Bartz, chief executive of Autodesk Inc. When shewas recruited six years ago to head the Silicon Valleysoftware company, profits were flat, and sales growthwas slowing dramatically. New software releases wereway behind schedule. The prior CEO had left amidopen rebellion by the company’s young and undisci-plined programmers, who viewed top management asan overbearing evil. Ms. Bartz didn’t hesitate to imposeher views. She rounded up employees she determinedwere “opinion leaders” and persuaded them that nomatter how inventive they were at 3 A.M. dreaming upnew software, they wouldn’t get anywhere if they didn’tdeliver products on time. The new version of the com-pany’s flagship product made it to market just fourdays late.

Within six months, she dumped marginal busi-nesses, made an acquisition and reassigned program-mers, ignoring those who advise new CEOs to respectthe past. “That’s a mistake,” insists Ms. Bartz. “If you

just do what’s already been done, how do you showyour value? You have to make tough decisions.” Shealso impressed employees with her personal courage.On her second day at Autodesk, Ms. Bartz, a formerSun Microsystems executive, was diagnosed withbreast cancer. Figuring that as a new CEO it wasn’t thetime to disappear, she refused to let her illness distracther from her job. She had a stopgap lumpectomy, thenworked a month before getting the radical mastectomyshe needed.

Straightforward and unpretentious, with a heartylaugh, Ms. Bartz links her leadership strength to know-ing that “you constantly have to reinvent yourself.”Since 1992, she has more than doubled Autodesk’srevenue to more than $600 million. “Human naturesays cling to what you have, whether that’s an old coat,a boyfriend, or a way of doing business,” she says. Aleader has to enjoy saying, “leave that behind.”

SOURCE: Carol Hymowitz, “In the Lead,” The Wall Street Journal, De-cember 8, 1998, p. B1. (Copyright © 1998, Dow Jones & Company, Inc.)

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Leadership Practices and Attitudes (Competencies) Common to 62 Companies

The five core leadership attribute buckets:

“IQ” (Mental horsepower).

“EQ” (Emotional Intelligence).

“Know” (Business and technical acumen).

“Grow” (personal development).

“Ego” (Strong sense of self).

Next, the four core leadership practice buckets:

“Tell” (Giving direction).

“Sell” (Influencing others).

“Initiate” (Making things happen).

“Relate” (Building relationships).

SOURCE: George O. Klemp, “Leadership Practices and Attitudes (Com-petencies) Common to 62 Companies,” in Putting It Together (CambriaConsulting, Inc., 1998).




That is what we explore in this and the next chapter. We begin in this chapter withan analysis of leadership in general as the exercise of power and influence, then con-tinue in Chapter 12 with the roles of formally appointed managers and their leader-ship choices.

Leadership as Influence

The core problem for leaders in organizations involves getting others to do what isnecessary to accomplish the organization’s goals. This is a complex process, becausethe goals as well as the means for accomplishing them are often unclear, subject todiscussion or negotiation, and can change over time. A leader’s boss (or bosses),peers, and subordinates all have ideas about what should be done and how to do it,and they are likely to try to get their ideas heard. Furthermore, leaders are only hu-man and unlikely to know everything, so they need to be able to alter their viewswhen others make good points.

Nevertheless, once goals are determined, leaders or managers must find a way tocreate the conditions that will cause (or allow) subordinates to work hard and to di-rect that work toward organizational ends. This may call for many different kinds ofinfluence behavior aimed in many directions: negotiating a larger budget; gettingother departments to deliver accurate and timely information; providing vision, di-rection, or training to subordinates; simplifying or complicating work; obtaining adeserved salary increase for someone, and so forth. All these activities—up, sideways,and down—ultimately are aimed at getting others, especially subordinates, to dowhat is necessary to accomplish successfully the work of the system being led.

Leadership is the ability to get men to do what they don’t want to do and like it.

Harry Truman

As countless leaders have discovered countless times, this is more easily said thandone. Subordinates don’t always know how to work well, don’t always work as hardas is necessary, and don’t automatically care about the unit’s or organization’s suc-cess. The fact is, leaders are interdependent with many others, especially their fol-lowers. They have an effect on, and in turn are affected by, those with whom theymust work. The key element is the influence the leader has on others and the influence

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Can Leadership Be Taught?

Leadership is no longer seen as the exclusive preserveof the inhabitants of executive row. The nurturing of“corporate Gandhis” has given way to a focus on de-veloping leadership abilities among employees at alllevels of our organizations. An executive, a manager, asupervisor, an hourly worker—all can learn to develop avision for the future. All can learn to accept new

responsibilities, to take risks, to build consensus andtrust among subordinates and peers. Certainly noteveryone has the potential of a Lee Iacocca. But every-one possesses innate leadership abilities to some de-gree and those abilities can be improved.

SOURCE: Chris Lee, Training, July 1989.





they have in return. For this reason we can think of leadership as a process in whichthe involved parties influence one another in particular ways. Influence is any act or po-tential act that affects the behavior of another person(s). Let’s look at the implications ofusing the concept.

First, influence cannot happen in isolation from others; it takes at least two to“tangle,” just as with interpersonal relationships. The person who wants to influencemust find someone to influence. Second, if you think about it carefully, you will seethat only in the most extreme situations could one person in an influence transac-tion have all the influence—that is, affect the other’s behavior without being affectedin turn by the other’s reaction. The machinist who leaps to attention when the bossgives an order, the secretary who bursts into tears when feeling that a request to worklate is unreasonable, the student who challenges an assignment due the day after va-cation—all exert influence on the person trying to influence them.

Cooperating humbly, for example, affects the person who is asking for coopera-tion and “pulls” more of the same from him or her. As Gandhi showed so well in In-dia, humble, passive noncooperation can have a profound influence on those givingorders. Even the person who follows directions he or she knows are wrong out offear of being fired or punished has influence on the behavior of the tyrant, allowingfurther exploitation and mistakes, because the directions were not resisted.

We must be careful then to remember that influence succeeds in moving othersin desired directions only when the net influence, the amount of A’s influence on Bcompared with B’s influence on A, is greater. In the classroom or on the job, stu-dents and workers can be less or more influential than teachers and supervisors.Leadership is net influence in a direction desired by the person possessing it.

To understand this process better, we need to look at various types of influence.One important aspect of influence is whether or not it is formal or informal, part ofa job’s definition or acquired in some other way. Formal influence is influence prescribedfor the holder of an “office” or a position in a particular social system. It is influence assignedto a position. The coach of a team has formal influence in initiating practice ses-sions, selecting starting players and substitutes, and so forth. Informal influence is in-fluence not prescribed for the office holder but nevertheless affecting other members of the socialsystem. On the same team, for example, there may be several players whose adviceother players and even the coach seek on such matters as techniques and strategyagainst opponents. Although by position the players have no special influence al-lotted or assigned to them, their knowledge or personal attractiveness, or both, givethem influence anyway. Influence based on special knowledge is expert influence,while influence based on personal charm is called charisma.

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Training Bosses to Use Influence, Not Raw Aggression, ImprovesTheir Effectiveness

Coaching—as executive development has come to becalled—is not new. But corporate shrinkage and thedawning era of flexible, decentralized management aremaking obsolete the idea that executives can expect tomuscle their way to a career pinnacle and then coastuntil retirement. Increasingly, they are expected to be, in

the words of the anthropologist Harvey Sarles, “auto-didacts,” or self-teachers and lifelong learners, whoseperformance will evolve and improve.

SOURCE: Barbara Presley Noble, “At Work: In Praise of ExecutiveCoaching,” New York Times, April 24, 1994, p. F23.




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In addition to the distinction between formal and informal influence (i.e., as-signed or unassigned), we need to add the concepts of legitimacy and illegitimacy.Legitimate influence is exerted by a person who is seen as having the right to do soby those influenced. In other words, legitimate influence is accepted as proper by theperson being influenced. Conversely, illegitimate influence is exerted by a personnot seen as having the right to do so by those being influenced. Illegitimate influ-ence is not accepted as proper by the person being influenced. The basis for consider-ing an influencer as legitimate may be (1) a positive assessment of his or her personalqualities, such as competence, experience, and age and (2) the acceptance of theprocess (such as election, appointment, or automatic succession) by which the per-son acquired a role calling for the exercise of influence. Legitimacy will usuallybe limited to areas within the scope of the system and its goals. For example, mostpeople will believe that the boss may legitimately give orders about how to sell amachine but not about where to go on vacation. But within the scope of the organ-ization, orders, requests, and directions will be seen as proper when they come fromsomeone who has acquired an office by an approved process or has personal quali-ties considered appropriate.

To despise legitimate authority, no matter in whom it is invested, is unlawful;it is rebellion against God’s will.

Leo XIIImmortale Dei

November 1, 1885

On the other hand, even in the army—where soldiers are taught to “salute the uni-form, not the man,” suggesting that mere appointment to rank guarantees legiti-macy—a soldier may refuse to follow direct orders under a variety of circumstances.To illustrate, if the commanding officer has disruptive personality characteristics orhas acquired his office in objectionable ways, such as perceived favoritism, theremay be rebellion. Furthermore, when influence is not seen as acquired legitimately,soldiers and other subordinates have many ways of subverting any orders from a per-son whose influence they do not accept, such as dragging their heels by following lit-erally all rules in the books. Going passive is a common way of resisting what is seenas illegitimate influence.

Because having formal influence does not ensure legitimacy nor does having in-formal influence ensure illegitimacy, it is useful to combine the two categories intothe four possible combinations, as shown in Figure 11–1.

By looking at the combinations, we can see the ways in which influence is exer-cised. Formal-legitimate influence is what is usually meant when people say “the bosshas the authority” to enforce particular behaviors. It is the influence both prescribed forthe holder of an office in a social system and seen as his or her right to exert by the other mem-bers of it. Many leadership activities in organizations involve formal-legitimate influ-ence by someone who has been assigned a role with supervisory responsibilities andwho can use organizational means to reward or punish subordinates. The right tohire, fire, promote, and adjust pay reinforces this kind of influence.

Because most people who accept jobs in an organization are reasonably willing toaccept directions from their “boss” on job-related matters, legitimacy is often takenfor granted and assumed to go with any formal role. During such times as the stu-dent strikes in the late 1960s and early 1970s or the rebellions of workers in France,it becomes evident that the legitimacy of those with formal organizational positionsis precarious and rests upon the attitudes of the “followers.” Students challenged therights of professors to determine subject matter, give exams and grades, hire and firecolleagues; and they exerted influence on other activities that had traditionally been





seen as part of faculty prerogatives. More recently, students have challenged collegetrustees about investments in companies using child labor, and challenged adminis-trators about pay levels of building and grounds workers. Pressure from workers inseveral European countries has led to change in what were traditionally consideredmanagement’s prerogatives. In several countries, workers must even be consulted forsuch decisions as plant location and new investments in equipment. Thus, theboundaries of legitimacy for decisions is changing. Furthermore, legitimacy, even forsomeone in a formal position, must be earned and may occasionally need renewal.At different times a formal leader may find legitimacy slipping away because of ques-tions about competence or about the way in which the person is leading. Similarly,some subordinates may see the boss as legitimate while others don’t. It is often thecase that an appointed leader is perceived as legitimate by those with similar back-grounds and as illegitimate by those with backgrounds different from the leader’s. Ascientist might not, for example, accept the influence of an engineer as a projectleader as readily as would another engineer. Since legitimacy is an attitude about aperson by other persons, it can change just as do other attitudes. Nevertheless, muchof the work of organizations is done because there is a considerable amount of le-gitimacy granted to those in formal positions; but that is by no means the only kindof leadership exerted.

A great deal of influence is based upon knowledge, expertise (whether perceivedor real), or personal charm rather than position.3 This informal-legitimate influence by amember of a social system stands apart from the prescribed influence of his or her office but isaccepted as within one’s rights by the others in the system. It is not predictable from orga-nization charts but is essential to organizational functioning. Some people knowthings or behave in charismatic ways that others value, regardless of position, andare given influence accordingly. The most expert auditor in an accounting officemay be consulted by other auditors and listened to even though he or she has noformal assignment to help others. The rewards and punishments available to thiskind of influencer are more personal—that is, he or she can give or withhold impor-tant information or support in return for gratitude and respect.

Leadership in classroom groups is often of the “expert” kind, with the mostknowledgeable member(s) of the group gradually becoming respected and listenedto even when there is no formal leader. In fact, among many student groups there isa widespread student norm that no peer should give orders or directions to anotherstudent, so even those students put in leadership roles by a class exercise often holdback from giving directions.

Conversely, a fellow student making a “grab for power” will usually be resisted byother students. Sometimes such a person has quickly volunteered for a leadership rolebefore others dare to and is allowed to take it despite feelings that “it isn’t right”; in

Examples of Types of InfluenceFIGURE 11–1

Formal (assigned) Informal (not assigned)

Boss gives work-related orders to Respected colleague helps you solve asubordinate: “Stop making widgets problem by showing you the properand begin making frammisses.” order to make calculations.

Teacher assigns an analytical paper, based Basketball benchwarmer notices flaw inon concepts in the text. opponent’s defense, convinces coach

to alter offense.

Boss makes strong hints about Co-worker threatens to beat you up if yousubordinate’s family life: “Send your continue to produce so much.son to a private school.”

Student put in charge of class discussion Fellow students ridicule you for askingby instructor. questions in class, despite instructor’s

request for questions.

Legitimate (accepted as proper)

Illegitimate (not accepted as proper)




that case, the student has formal-illegitimate influence, which may not last long, unlesshe or she is seen as helping the group reach its goals. Similarly, in organizations wheremembers are accustomed to having considerable say in matters affecting them, theboss’s decision to create a new position located between him or her and the others(“because the work load is too heavy for me”) can result in resentment toward who-ever is put in that new job and lead only to grudging cooperation. If that person, how-ever, has the formal authorization to administer some organizational rewards andpunishments, he or she may end up with considerable influence anyway.

Finally, the person who acquires influence over others by personal access to some valued re-wards or feared punishments is using informal-illegitimate influence. Physical threats by afellow worker can coerce compliance that would otherwise be refused, as can specialrelationships with higher-ups. In one New Hampshire school system, for example,by maintaining a close relationship with several powerful school board members,the music director forced principals to release students for weeklong band trips andto arrange schedules to suit his convenience. He thus obtained more influence overprincipals than was called for by his position or was seen as his right by them. Al-though he obtained compliance, he also created considerable resentment and wasconstantly criticized behind his back by the principals.

I must admit my management style was too simple sometimes.

Chinese track coach Ma Junren, after confirmingthat he occasionally beat up members of his world-

class squad, Newsweek, April 3, 1995

Taking Initiative as an Act of Leadership

Have you ever found yourself in a room that was so hot and stuffy that you and otherstudents were having trouble concentrating on the lecture or discussion? What do youdo? Wait and hope the instructor will recognize the problem and call a break; or raiseyour hand, point out the difficulty, and suggest opening some windows and taking a

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A Title Is No Guarantee of Power

And these considerations . . . hamstrung [Mayor] La-Guardia in his dealings with [Robert] Moses: Moses’popularity; Moses’ immense influence with a governorand a legislature from whom the mayor constantlyneeded favors; Moses’ ability to ram through the greatpublic works that the mayor desperately wanted . . .scandal-free and in time for the next election. Withgood reason, he doubted whether anyone else could.The powers that the mayor possessed over Moses’ au-thorities in theory he did not possess in practice. Polit-ical realities gave him no choice but to allow Moses toremain at their head. And the mayor knew it.

Moses knew it, too. After reading the bond agree-ments and contracts, LaGuardia dropped all further

discussion of the authorities’ powers. Moses neverraised the matter again. But thereafter he treated La-Guardia not as his superior but as an equal. In the ar-eas in which he was interested—transportation andrecreation—Robert Moses, who had never been electedby the people of the city to any office, was thence for-ward to have at least as much voice in determining thecity’s future as any official the people had elected—in-cluding the mayor.

SOURCE: Robert A. Caro, The Power Broker: Robert Moses and TheFall of New York (New York: Alfred A. Knopf, © 1974).





break? Raising your hand could be an act of leadership. To wait for the designatedleader (instructor) to act could mean missing an opportunity to make it a better class.Taking initiative might have the payoff of enhancing your influence (or status) butalso involves the risk of being “shot down” by the formal leader of the class.

In the next chapter we examine the obligations and choices of those who havebeen formally appointed to managerial positions, that is, who are in a formal role.In this chapter we have been discussing the exercise of influence by anyone and havedefined leadership as influence. We might also define leadership as those actions thatmove a group toward its goals (such as opening a window when the room is stuffy). Thedistinction between formal and informal leadership is a useful reminder that asgroup members and as subordinates anyone can exert influence (leadership)—and of-ten should. In small work groups, it is important for all members to take initiative.Similarly, it can be important that a subordinate exert initiative in a staff meeting ora committee meeting and not just wait for all leadership to come from the desig-nated manager or chairperson.

How People Are Influenced

There are three processes (not mutually exclusive) by which people are influenced—compliance, identification, and internalization.4 The very same behavior (namely, doingwhat you are told to do by another person) can stem from any one or a combinationof these processes.

Compliance amounts to doing something because of the costs of not doing it. Yougo along with the “order” on the outside, but inside you may feel resentment or res-ignation. Any leader’s influence can rest on compliance, particularly where there isfear of punishment or a desire to gain some reward; this may be the only way inwhich an informal-illegitimate leader can exert influence. Where compliance is op-erating, leaders will be successful only as long as they have control over whatever itis followers need or want.

Identification occurs when you are influenced by someone because of the attrac-tiveness of that person, because the person either is likable and has charisma orrepresents something to which you aspire (e.g., an important position). Formal,designated leaders or managers often exert influence because subordinates identifywith them. They may also be legitimized by their subordinates through thesame process.

Identification with a charismatic leader can dramatically affect behavior for peo-ple who want to believe in lofty goals that will somehow be ennobling. When suchpeople see a leader as having a grand vision of what is possible and offering specificmeans for achieving their dreams, they identify with the leader and dedicate them-selves to the cause. This can lead to extraordinary efforts by followers on behalf ofthe leader and, thus, unusually high organizational performance. That is why effec-tive high-level executives spend so much time creating a vision or “story” aboutwhere they see their organization (or unit) going and then telling and retelling it tocolleagues, subordinates, and outsiders.5

Ironically, it has been claimed that charismatic leaders only succeed because theymake followers feel weak and dependent. But some charismatic leaders can make fol-lowers feel more powerful, more confident, and more capable, not less.6 Followerscome to see themselves as achieving their own goals through the leader, not as hav-ing the leader’s goals forced on them. When this happens, influence through iden-tification with the leader can spread to another mode, internalization.

Internalization, the third kind of influence, happens when leaders have the neces-sary expertise and values to be credible to their followers; they come to believe thatwhat the leader suggests is in fact the best course of action for them. The leader’sopinions are seen as valid and trustworthy. The effect is that followers internalize theleader’s opinions, thus giving full legitimization to the leader—formally designatedor not.




. . . the ultimate paradox of social leadership and social power. To be an effective leader,one must turn all of his so-called followers into leaders.

David C. McClellandPower: The Inner Experience

Over the long run, the most successful managers are those whose influence isbased on credibility—that is, where the followers are convinced by the logic of theleader’s ideas and requests and internalize the influence.

You can see how a combination of these factors can have different effects. Com-pliance may be necessary under certain conditions (e.g., an emergency or when thetask is minor and implementation is easily enforced) but is difficult for a manager tosustain. Some people will do what you want strictly out of compliance and some be-cause they identify with you or your position. To maximize your effectiveness as aleader, however, it is best to build credibility and reach people through internaliza-tion, so that they will do what is necessary because they want to.

Generating Employee Commitment

The important outcome of both identification and internalization is commitment,which is an attitude driven from within the person. You know when you are com-mitted to something—a person, an activity, a belief—when your behavior is moti-vated by forces inside yourself and not from outside pressures, as with compliance.In the past, organizations have depended heavily on compliance and control to ac-complish their goals; today more and more organizations are attempting to buildemployee commitment, which obviously has more long-lasting benefits. Leadershipefforts have been directed to three major areas: the work itself, the relations amongpeople, and the organization as a whole.

Approaches to building commitment to the work itself include both formalmethods, such as work redesign, and informal ones, such as permitting employees ahigh degree of freedom to manage their own work procedures. Approaches to gen-erating interpersonal commitment also have included formal and informal methods

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Managing Your Career: Silicon Valley Hybrid—A Boss Who MakesOthers’ Ideas Pay Off

At McKinsey, the emphasis was on getting the right an-swer, [Gregory Slayton, CEO of ClickAction, Inc.] says.But “Silicon Valley is all about the strength of your net-work. If no one answers your call, you can’t get that an-swer implemented.” . . .

To succeed as a Silicon Valley CEO, he says, re-quires more than “intellectual firepower.” He considershimself an “implementer,” whose successes have comemostly from other people’s ideas. What is needed, hesays, is the ceaseless drive to make things happen, thewillingness to make a decision when you have only

10% of the information you would like to have, and theability to forge trusting relationships.

That ability is critical in motivating the workers of thenew economy, he says. “You have to get them inter-ested in the greater cause you’re pursuing,” he ex-plains. “If not, they’re out there playing video gamesand trading on E*Trade.”

SOURCE: Hal Lancaster, “Silicon Valley Hybrid: A Boss Who MakesOthers’ Ideas Pay,” The Wall Street Journal, October 26, 1999.





such as planned team-building or informal encouragement of collaborative norms.Similarly, organizational commitment is developed in both formal and informalways. The “transformational” leader, who inspires people to excel and articulates ameaningful vision for the organization, uses both ways to build employee commit-ment.7 In Chapter 12 we introduce you to the concept of “developmental leader-ship,” which is similar to that of transformational leadership, but which goes beyondit by spelling out practical applications in the workplace. It might interest you toknow that the traits of the transformational or developmental leader are claimed tobe more typically characteristic of women than of men. The implications of this forfuture organizational needs and for personal learning and opportunity are extremelyimportant.8 However, recent survey evidence raises questions about whether thereare real differences between men and women managers:

. . . a 15-year survey of 41,000 executives—25% of them female—at 5,000 companiesshows that women are slightly more high-handed than the guys are when makingdecisions . . . Discovery Learning . . . came to that conclusion by investigatingwhether managers solve business problems autocratically—preferring to make unilat-eral decisions—or “inclusively . . .” [W]here an autocratic style was deemed appro-priate, women chose “my-way-or-the-highway” 35% of the time, guys only 31.5%. . . “Did [women managers] make it to these levels because they operate more likemen, or is there basically no difference?” . . . if your boss is a Ms., don’t automati-cally expect her decision-making to be warm and fuzzy.9

Finally, it is important to recognize that, while the three areas of commitment dis-cussed above tend to be related, they also exist independently of each other. Manyworkers are committed to their work and not to their colleagues or to the organiza-tion as a whole. And many employees are committed to their “team” and even tothe organization and feel a very low level of identification with the work they are do-ing. Because there are a variety of combinations of the three dimensions, it is im-portant for a manager to develop a diagnostic profile of the three as they fit hisor her part of the organization. Such a diagnosis allows for a focused approach to

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Winning Strategies of Corporate Stars

Headhunters Neff and Citrin foundAmerica’s top business leaders sharethese six principles:

1. Live with integrity, lead by example. “Integritybuilds the trust in senior management that is . . .critical for high-performing organizations.”

2. Develop a winning strategy or “big idea.” “A suc-cessful leader must go to the company’s rootsand build on the things the organization trulydoes best.”

3. Build a great management team. Great leadershired managers “whose skills and experiencescomplemented their own, but whose passion,attitudes, and values were one and the same.”

4. Inspire employees to greatness. “Communicatecontinuously, listen carefully, genuinely toleratefailure as a learning experience.”

5. Create a flexible, responsive organization. “Thebest leaders have redesigned their organizationsto make sure decisions can be made fast.”

6. Use reinforcing management systems. “Compen-sation . . . must be consistent with and reinforcethe values and strategy of the organization.”

SOURCE: “In Search of Leadership: A Talk with Headhunters Turned Au-thors Citrin and Neff,” Business Week, November 15, 1999, p. 172.(Copyright 1999 McGraw-Hill, Inc.)




actions that will address problems of commitment where they exist. In the Manage-rial Tools box above, we have listed some of the key issues that pertain to employeecommitment as they affect the individual, interpersonal relationships, group behav-ior, and the organization as a whole.

Power

The capacity to exert influence is power. (Often “power” and “influence” are used inter-changeably.) People who have the ability to exert one or more of the four types ofinfluence have power, which can be used toward the organization’s ends or towardsubgroup or individual goals, including those in direct opposition to organizationalgoals. As suggested earlier, no one is completely without influence, but some peoplehave more net influence than others and hence more power.

Power is often perceived to be a bit “dirty,” at least in the United States, some-thing vulgar, but it is more than a set of sneaky tactics for grinding others into thedirt; power in organizations is the ability to make things happen.10 Organizational workcannot be done without that ability, and managers need to understand it in order tobring together the people and resources to accomplish what must be done and toavoid the negative consequences of power differentials.

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Gaining Commitment from Your Employees: Some Key Points

For the individual, it depends on:

1. Involvement.2. Choice.3. Meeting positive expectations.4. Feeling supported and valued.5. Need fulfillment.6. Feedback that facilitates improvement.7. Intrinsic satisfactions.8. Challenge and opportunities to grow.9. Being treated fairly.

10. Affirmation of self-concept.

In interpersonal relationships, it depends on:

1. Mutual support, acceptance and reinforce-ment of self.

2. Openness where needed and appropriate.3. Trust and confidence (mutual).4. Compatible styles:

a. Similar orb. Complementary.

5. Acceptance or appreciation of differences,or both.

6. Opportunities to problem solve jointly.7. Willingness to manage conflicts.

For a group, it depends on:

1. Norms that support organizational goals.2. Cohesiveness around those norms.3. Rewards at a group level.4. Group being valued by organization.5. Acceptance of individual differences in abili-

ties, preferences, and values.6. Ability to match member resources to any

given task.

For the total system, it depends on:

1. The parts being aware of the whole.2. Groups being willing to accept each other’s

legitimacy and importance.3. Willingness of people to interact across

group boundaries.4. Recognition of the importance of reciprocity.5. Appreciating the importance of diversity with

respect to:a. Ideas andb. People.

SOURCE: Stephen L. Fink, High Commitment Workplaces, QuorumBooks, 1992.





Sources of Power in Organizations

How, then, is power obtained by individuals in organizations? In general, The morelegitimate one is perceived to be, the greater the likelihood of acceptance of one’s at-tempts to influence, and the less resentment at going along.11 Power goes to thosewho are seen as having a right to it. Conversely, the less legitimate forms of influ-ence breed resistance and resentment, although they will probably enhance thepower of someone who already possesses other kinds of legitimate influence.

Additionally, informal influence is often necessary for those with formal influ-ence if they want more than drudging cooperation; when a formally designatedleader does not have some knowledge seen as helpful by subordinates, it will be dif-ficult to secure more than token compliance. As organizations become more com-plex and technically demanding, more people in leadership positions do not havethe technical expertise necessary to gain influence beyond that of their own job de-scription, making it hard for them to get full cooperation from those who knowmore than they do about some other aspects of the job. They must then find waysof gaining informal influence through their own personal attractiveness and theirability to make friendly relationships—or they must settle for a low-power positionrelative to their subordinates.

Perhaps the primary source of power is the ability to enhance the organizationpositively in relation to its “environment” or key problems.12 Those who can helpthe organization achieve its goals by overcoming the most difficult, pressing, anddangerous problems are likely to acquire power. A marketing expert in a companythat can sell everything it can make but cannot solve its production problems is lesslikely to gain power than the production engineer who can eliminate the bottle-necks. So it helps either to acquire skills that are (and will be) critical to the organi-zation or to seek employment where the skills one has are most likely to be needed.

MANAGERIAL BULLETIN

Tyrants Beware

Nobody minds being subjected to the power of some-body who’s genuinely interested in getting the job doneand making more money and extracting maximum per-formance. But nobody wants to be told that they have tohave their pencils sharpened and the erasers all facing

in the same direction before they leave the office atnight.

SOURCE: Michael Korda, “Psychodynamics of Power,” Mainliner, March1977.

MANAGERIAL BULLETIN

Rep. Bolling Takes His Leave of Power

It took me 32 years to realize that it’s sometimes moreimportant to have the trappings of power than power it-self. If you’ve got a good-looking room with a nice chan-delier, your colleagues may think you’ve got power.

Actually, all you’ve got is a chandelier and room. Wash-ington is full of illusions like that.

SOURCE: Dennis Farney, The Wall Street Journal, January 1, 1982.




Furthermore, it helps to do things that are not routine, that are unusual or ex-traordinary in the organization. A person who performs critical tasks in a way that isalready established and routinized will receive less power than a person who devel-ops new methods or procedures, starts a new unit or task, creates a new project orproduct.13 That is why those who are organizationally ambitious do not like to bethe second or third person in a job; they would prefer to be the first to do a job, sothey can most easily leave their mark. And in any job they move into, they oftenseek early changes in something, even office layout or decor, to show that they in-tend to do things differently.

That suggests a third important aspect of power acquisition: It is not enough to bedoing extraordinary, critical activities; one’s efforts must be visible and recognized.Power goes not just to those who do well, but to those who are also seen to do well.14

(In fact, some cynics claim that appearance is all, though it is hard to sustain powerwhen one does not actually produce.) Those who want power must find ways toachieve recognition. Among other things, it is a political process.

This can happen in many ways. A well-written and well-timed report can helppromote visibility, as can a well-presented oral report at a meeting. The opportunityto make a presentation to higher-ups creates a natural chance for “showing one’sstuff” and for demonstrating the importance and relevance of the work done. Simi-larly, serving on committees, often seen as a nuisance, is a chance to show others be-sides one’s boss what one can do. “Doing one’s homework” before meetings oftenhelps both to make a good impression and to lead to more responsibility and thuspower within the committee. Those who want power look for responsibility, forchances to demonstrate ability to get things done.

Through committee work or social contacts, power seekers make connections withone or more people higher in the organization. A higher-up who thinks a personshows promise might become a kind of “sponsor” who will look after the aspirant’scareer, help create opportunities, and build reputation. Also, when people are per-ceived as “having a friend or friends in high places,” then others may defer to themor seek them out even without direct intervention on the powerful person’s part.

Because power is a social process of influencing others to act, it comes in partfrom being able to do things for others that obligate them to be helpful in return byfulfilling the norm of reciprocity.15 Thus, the person seeking power needs to findways to be helpful to others in the organization. Volunteering to handle unpleasant

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Management: When Young Managers Deliver the Pink Slips

Many 20-somethings are managers, and holding ontoemployees, not letting them go, is their main concern.But when pink slips must be delivered, these youngbosses often have to deliver them. . . .

Managers have always had to dismiss underlingswhen their performance lagged or the company’s prof-its sagged. Even Amazon.com and iVillage.com re-cently had to trim their staffs for economic reasons. . . .

But not so long ago, the bearer of bad tidingswas usually an old pro, or . . . old enough to knowhow to cope with the emotions surrounding it. Today,

increasingly, the dirty work is done by people a fewyears out of college for whom management has mostlymeant recruiting employees with stock options andplaying the host at happy hours. . . .

Aside from the legal implications, young executivesare often not equipped to handle the emotional side offirings.

SOURCE: Charles Butler, “Management: When Young Managers Deliverthe Pink Slips,” New York Times, February 16, 2000, p. 10. ©2000 TheNew York Times Company.





tasks, finding ways to make others’ jobs easier, and doing favors whenever possibleare all ways of creating obligations, which can be collected on when needed. That isexactly how politicians, who have to be interested in power, build it.

Another way of looking at this is in terms of control of key rewards and punish-ments in the organization. Power reflects the ability to give rewards or punishmentsin order to get others to do what one believes needs to be done.16 The more a per-son has access to controlling rewards and punishments, the greater his or herpower.17 Thus, a person who can give the formal rewards or use the formal punish-ments of an organization—hiring, firing, promoting, adjusting salary, allocatingchoice assignments or space, giving recommendations, and so forth—and give infor-mal rewards or punishments, such as help, information, and liking, will have themost power. Just what the rewards and punishments are depends on the organiza-tion and the perceptions of those in it; but whatever it is that people value or fear,those who control it will have power to influence behavior. Attention to what the re-wards are to those in the organization, who manages them, and which departmentsor units currently get them in greatest proportion, can aid in determining how to getcontrol of them. At the very least, power seekers figure out what rewards they al-ready control so that they can more wisely use them to create obligations or inducecooperation when needed. One common accessible reward (even at lower levels ofthe organization) is finishing, on time, work that someone else needs and is waitingfor. That builds gratitude—or, as it is called in some organizations, chits—which canbe “cashed in” when needed.

MANAGERIAL BULLETIN

Are You More of a Street Fighter or a Jekyll and Hyde?

Most bosses think they do a pretty good job of keepingtheir subordinates happy. Don Bibeault has no such il-lusions. “I’m not a jolly fellow who’s fun to be with,” . . .“I’m extremely dedicated and determined, and I don’thave time to sugarcoat problems. If that’s consideredabrasive behavior, so be it.”

[He claims] that being a street fighter is the only wayhe could be effective. His harsh style helped him reviveor liquidate 11 companies . . . as a turnaround special-ist. But it did lead to occasional confrontations.

SOURCE: Tony Lee, “Are You More of A Street Fighter or a Jekyll andHyde?” The Wall Street Journal, June 11, 1996, p. B1.

MANAGERIAL BULLETIN

Is Craig Weatherup Too Nice for PepsiCola’s Own Good?

The chief executive of PepsiCo Inc.’s global beveragearm is widely regarded by employees as a benevolentboss. . . .

One school of thought has it that Pepsi can neverbeat an increasingly aggressive Coca-Cola Co. withouta certain ruthlessness in the executive suite. “What’sneeded at Pepsi is some basic brutality because whenyou’re dealing with killers that’s the only thing that willhelp you prevail. . . .

“It staggers me that for whatever reason being niceis seen as being inconsistent with being tough,” says[Weatherup]. [His] argument is this: If you’re a visionarybut you’re mean, employees won’t follow you.

SOURCE: Nikhil Deogun, “Pepsi’s Mr. Nice Guy Vows Not to Finish Lastin Battle with Coke,” The Wall Street Journal, March 19, 1997, p. B1.




One interesting aspect of the kind of power that is associated with rewards is thepower obtained by helping to relieve people’s anxieties (reduce their tensions). “Gota problem? Go see Joe. He’ll help you work it out.” In fact, when this kind of poweris carried to an extreme, unusually high expectations can be imposed on the holderand may even put a strain on that person’s ability to retain that power.

Pfeffer18 points out the power one obtains by being seen as someone who can re-duce uncertainty in an otherwise chaotic situation. Given the nature of organiza-tions today, this source of power is undoubtedly on the increase. Most people havea limited tolerance for uncertainty (or ambiguity); the person who can help to re-duce that uncertainty is likely to attract a following. It is not unlike the following ofany person who is viewed as “having the answers.”

None of the methods described provide for easy access to power; in fact, sheerwillingness to work hard is almost always a requisite for acquiring power. As shouldbe clear by now, hard work alone may not be sufficient—it is necessary to work atcritical, unusual tasks with or for people who recognize what you are doing—butwithout hard work it is extremely difficult to acquire power. Furthermore, A desirefor power with little genuine concern for the well-being of the organization andfor other members can be very destructive to the organization—and even to thepower seeker.

Consequences of Possessing Power

Regardless of the source of power, its possession tends to lead toward certain conse-quences, not all positive. These can be stated in the following propositions:19

1. The more power attributed to a person, the more he or she is the recipient of:a. Communication.b. Solicitous behavior.c. Deference by others seeking power.

This proposition suggests that those with power will be deferred to and that,when those with less power are in the presence of powerful persons, they will addresscomments to them more than to one another. Large discrepancies in power betweenindividuals, however, can interfere with successful work. If subordinates do not havesufficient power, they often will not be able to get their work done, because theycan’t get the resources or responses they need. This in turn reduces the leader’spower. Furthermore, large power gaps often lead to avoidance of the high-power per-son by the low-power person and to distorted communications—telling the powerfulperson what one thinks that person wants to hear. Any powerful person will have to

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“That Report Is on My Coffee Table”

Many of your readers . . . have aspirations of becomingwealthy and powerful. If they succeed, however, I hopetheir egos will not require offices with private saunasand push-button controls. If one is important and pow-erful, the right people know it. If not, handpainted chinawill not change it.

With the economy in a depression, dividends beingomitted, and millions unemployed, it is embarrassing to

read about the conspicuous consumption and crys-talline egos of America’s top executives. What we needare offices that look like offices, not living rooms.

SOURCE: From a letter to the editor of The Wall Street Journal by SamBosch, January 28, 1982.





be keenly aware of this problem and work hard to find ways to make less powerfulpeople feel comfortable enough to tell the truth. Without accurate communications(and probably multiple sources), a powerful person will lose touch with actual feel-ings and is likely to make mistakes.

2. The more a person is treated as though he or she has power, the greater will behis or her self-esteem.

Feeling deferred to, powerful people have a tendency to begin to view themselvesas important, which enhances how they feel about themselves. Not surprisingly,then, people who are powerful tend to seek one another out. Power breeds morepower. Thus,

3. The more power attributed to a person, the more that person will tend to iden-tify with others who also have power.

4. Those with high-attributed power are attracted to and communicate more withothers with high-attributed power than with those who have low-attributedpower.

Many political leaders have been known to shift their attention and allegiancefrom their constituencies to their fellow politicians. The same thing can happen inan organization, especially as people climb increasingly higher in the hierarchy. Areyou familiar with instances in which an emergent social leader in a group was ap-pointed formal leader by the system, thus enhancing his or her degree of influence?

MANAGERIAL BULLETIN

Bite Your Tongue When Evaluating Your Boss?

In a study at an insurance company, managers weremore positive about upward feedback when their em-ployees signed their name to upward appraisals. Butthe opposite was true for the employees. They ratedtheir manager’s leadership style more positively whenthey were held accountable for their opinions. They

liked the process better and were more truthful onlywhen their views were kept anonymous.

SOURCE: Leo F. Brajkovich, “How Truthful Should You Be When Evalu-ating Your Boss,” (a research translation of a study by David Antonioni),Academy of Management Executive 9, no. 4 (1995).

MANAGERIAL BULLETIN

CEO Disease: Egotism Can Breed Corporate Disaster—and the MaladyIs Spreading

Pampered, protected, and perked, the American CEOcan know every indulgence. The executive who finallyreaches the top of a major corporation enters an exclu-sive fraternity. The CEO’s judgment and presence areeagerly sought by other captains of industry and poli-cymakers. CEOs zip around the world in private jetsand cash the heftiest personal paychecks in industry.

They take home 85 times what the average blue-collarworker makes, unlike their counterparts in Japan, wherethe ratio is closer to 10 to 1.

It is a job that can easily go to one’s head—andoften does.

SOURCE: Business Week, April 1, 1991




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Very often the individual is then seen to “change”; he or she is seen as less friendlyto “us mere workers” and as playing up to the big bosses. This frequently happens aspeople find themselves in new leadership roles, having influence over people inareas never before experienced.

In fact, one of the dangers of superiors having great power differentials over sub-ordinates is that they begin to perceive any successes as due to their own skills andto discount the capacities of the subordinates. Great power differentials lead to over-estimates by the powerful of their own contributions and to blindness to the con-tributions of others.20

By examining these propositions, you can see why it is often said that power cor-rupts. The entire constellation of behavior and relationships that follow from thepossession of influence generates a cycle in which people with high power tend tobecome more and more differentiated form those with low power, even though eachis dependent upon the other. The person with power has it only because it is givenby others; it ends the moment those who are doing the giving choose not to do so.A leader is a leader only so long as there are followers. It certainly raises the questionof who really possesses the power, the one who leads or those being led.

There go my people. I must find out where they are going so I can lead them.

Anonymous

Another consequence of power for someone new to a position is the likelihoodof being closely observed by subordinates about where the leader’s loyalties and pri-orities will be, how open they can be, how friendly and close the leader will allowthem to be, and the like. Such early “testing” is often symbolic: The test is not di-rect, and the leader’s reactions are carefully scrutinized for favorable and unfavor-able signs of what is to come. A leader who is unaware that such testing is inevitablecan make inadvertent mistakes that are hard to live down, sending messages that dis-courage future openness or cause resentment about assumed attitudes of superiority.

Consequences of Not Possessing Power

Although too much power can indeed be corrupting, so can too little. Becausepower is needed to make things happen in organizations—being without it means

MANAGERIAL BULLETIN

Charmed Forces: Army’s “Baby Generals” Take a Crash Course inSensitivity Training

“Each and every one of you has something that makesyou a jerk. Some of you have more than one. I know.I’ve talked to you . . . work on losing that ugly part ofyour personality.”

[Lt. Colonel Olsen] suggests that doubters ask theirspouses what he’s talking about: “They know, andthey’re dying to tell you.” . . .

Gen. Burnette warns that “The first deadly sin of thegeneral officer is arrogance. “Bask in the glow—and getover it.” “You’ll find,” says another lecturer, “there aren’ta whole lot of people who will tell you the truth anymore.”

SOURCE: Thomas E. Ricks, “Charmed Forces,” The Wall Street Journal,January 19, 1998, p. A1.





insufficient resources, information, and support—managers who lack it have diffi-culty being effective. The manager who does not know what is going on, can’t getthe needed budget, and is not backed by higher-ups will inevitably be resisted bysubordinates. Why should they cooperate with someone who can’t deliver?

As a result, managers who are in positions that yield too little power (or who filltheir positions ineptly and lose what power they had) tend to:

1. Overcontrol subordinates, try to make them cooperate.2. Become petty tyrants, taking out their frustration on anyone they can

dominate.3. Become turf-minded and rules-oriented, carving out a fiefdom where they can

reign supreme. 21

In this way, powerlessness also corrupts, since managers who become so domi-nating are seldom effective. Their attempts to find someone on whom to exercisepower only increase the resentment of their victims, causing even stronger attemptsat domination, more resistance, and so on. Without the proper tools, few managerscan be successful.

MANAGERIAL BULLETIN

The Bureaucrat Gets the Last Word

Ed Garvey was scheduled to make a business trip andneeded a cash advance. He went to the controller’s of-fice to get the necessary signature on a form in order toreceive the cash. Mr. Pomeroy, an administrative assis-tant, was the person whose signature Ed needed. Butfirst Ed had to get past Mrs. Arnold, the secretary andreceptionist in the controller’s office. The Conversationwent like this:

Ed: I’d like to see Mr. Pomeroy for just one minute. Ineed his signature for a cash advance.

Mrs. Arnold: Mr. Pomeroy is very busy, so you’ll justhave to wait. Please sit over there.

Ed: Mrs. Arnold, I really have to get back to my of-fice. Could you ask Mr. Pomeroy if he could take aminute to sign this?

Mrs. Arnold: Well, I hate to interrupt him, but I’ll seeif he can take a moment. (Goes into Pomeroy’s officeand returns after about two minutes.) He’ll see you,but you may have to leave the form here.

Ed goes into Pomeroy’s office and explains that this tripwas a last-minute thing and he was under time pres-sure. The conversation went like this:

Pomeroy: You know that at least 24 hours is re-quired for approval of a cash advance.

Ed: I know, but I don’t have 24 hours before I haveto leave. I need the cash advance today.

Pomeroy: Well, I don’t know if I can take it uponmyself to sign this. If I break the rules for you, I couldend up with endless requests like this from others.

Ed: Look, this is an exceptional situation. The rulesdon’t cover every situation.

Pomeroy: I know, but I do have a job to perform.

Ed: Would you get into trouble if you signed it?

Pomeroy: No, but I believe in following proper pro-cedure, Mr. Garvey.

Ed: I do too, but sometimes other things are moreimportant than rules. Is there someone over you I cango to?

Pomeroy: I don’t think that will be necessary. I’llmake the exception this time, Mr. Garvey, but pleasetry to give me the proper notice in the future.

Ed: That’s very nice of you, Mr. Pomeroy. Thank you.

When Ed walked out, he had the signature, but he feltlike he bought it with his soul.




Some Currencies of Influence

Often people see themselves as having little power, because they do not occupysome formal position of power. But Cohen and Bradford22 point out that “peoplealso underestimate their power, because they aren’t creative in seeing connectionsbetween what they have and what someone else wants.” These connections are like“currencies,” which serve as a basis of exchange: “I give you my time, and you giveme appreciation.” “I generate ideas, and you feel empowered to act in ways that I, inturn, value.” Managers have a vast array of currencies to influence their subordi-nates, their peers, and their bosses. Students don’t even begin to recognize the cur-

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MANAGERIAL TOOLS

Currencies Frequently Valued in Organizations

Inspiration-Related Currencies

Vision Being involved in a task that has larger significance for unit, organization, customers, or society.

Excellence Having a chance to do important things really well.

Moral/ethical correctness Doing what is “right” by a higher standard than efficiency.

Task-Related Currencies

New resources Obtaining money, budget increases, personnel, space, and so forth.

Challenge/learning Doing tasks that increase skills and abilities.

Assistance Getting help with existing projects or unwanted tasks.

Task support Receiving overt or subtle backing or actual assistance with implementation.

Rapid response Quicker response time.

Information Access to organizational as well as technical knowledge.

Position-Related Currencies

Recognition Acknowledgment of effort, accomplishment, or abilities.

Visibility The chance to be known by higher-ups or significant others in the organization.

Reputation Being seen as competent, committed.

Insiderness/importance A sense of centrality, of “belonging.”

Contacts Opportunities for linking with others.

Relationship-Related Currencies

Understanding Having concerns and issues listened to.

Acceptance/inclusion Closeness and friendship.

Personal support Personal and emotional backing.

Personal-Related Currencies

Gratitude Appreciation or expression of indebtedness.

Ownership/involvement Ownership of and influence over important tasks.

Self-concept Affirmation of one’s values, self-esteem, and identity.

Comfort Avoidance of hassles.

SOURCE: A. R. Cohen and D. L. Bradford, Influence without Authority (New York: John Wiley & Sons, 1990).





rencies they have to influence their instructors, ranging from nods of the head dur-ing a lecture to high levels of performance on papers or exams. The ManagerialTools Chart above, shows a variety of currencies that are valued in organizations. Al-though many are not likely to fit your present circumstances, you might explore thechart and possibly discover some influence currencies you do in fact possess andnever realized you have. Also, try using the Personal Application Exercise at the endof the chapter.

Liking versus Respect

It is not uncommon for those who have power to be less well liked; as noted in thegroup chapters, the group members who contribute most to getting tasks accom-plished are usually most respected but seldom most liked. Informal task leaders of-ten have to trade liking for respect; while occasionally someone can get both, mostoften: The more a leader strives for popularity, the less effective he or she becomesas task leader. Also, the more the leader strives to maintain task leadership, the morehe or she will lose popularity.23 Can you think of any conditions where these propo-sitions would not be true? How important each factor is in comparison with theother depends on the nature of the situation and the person involved in the leader-ship role. When a strong task leader brings a group through a very difficult situation,popularity may soar, at least for awhile.

All leaders have to struggle with the question of how close they can be with theirfollowers. Can a leader also be a friend? If so, does this still allow him or her to pushthem into working harder? Or, if the leader remains distant, will the followers stillfeel the loyalty and commitment necessary to put forth sufficient effort?

MANAGERIAL TOOLS

Guide to Managing Your Boss—Or Anyone Else You Don’t Control

Understand your boss and the forces surroundinghim or her:Boss’s goals and objectives.How boss is rewarded.Pressures on boss:

From his or her boss.From the organization.From the environment.

Boss’s power (capacity to mobilize resources).Boss’s strengths, weaknesses, blind spots, and

hot buttons.Boss’s managerial style—preferred degree of:

Control.Information received and shared.Formality.Openness.

Work to make your boss’s life easier:Aid in accomplishing boss’s goals.Increase boss’s visibility and reputation.Pick up tasks boss doesn’t like or isn’t good at.Tie your requests/preferences to boss’s /organiza-tion’s goals; show how giving you what you wantwill help achieve the goals.

Ask boss for evaluation of how you can performbetter:If boss is uncomfortable, offer self-appraisal toease discussion.Keep boss informed:With frequency preferred by boss.With level of detail preferred by boss.In form preferred by boss:

Oral?Brief reports?Extensive reports?Executive summary?

Work to demonstrate dependability; keepyour word.Reward boss whenever he or she manages in wayyou prefer:Many bosses feel underappreciated.Public praise increases boss’s reputation, aiding obtaining of resources.

SOURCE: Based on J. J. Gabarro and J. P. Kotter, “Managing YourBoss,” Harvard Business Review, January–February 1980; and Allan R.Cohen, “How to Manage Your Boss,” Ms. Magazine, February 1981.




For some situations and people, the task maintenance function must take prior-ity over social maintenance; in other situations and for other individuals, the oppo-site might be true. The important thing to keep in mind is that there is more thanone option and that there may be some trade-offs in each.

But why does this dilemma occur? Why is it so difficult to mix these functions?For one thing, not many people are really good at both; as a result, the task leader islikely to be someone who has the best skills or abilities related to the task (as itshould be), and the social leader is often the most outgoing person in the group. Ifthat’s the case, then other group members tend to become dependent upon the taskleader and may even see him or her as superior to the rest of the group. While thismay generate respect for that individual, it also tends to breed resentment.

Furthermore, because people are social beings and usually have other interests inaddition to interest in working well—or will retreat into socializing when tasks becomeunpleasant or might lead to conflict—task leaders occasionally have to refocus atten-tion back to getting the task done. As a result, when the task leader pressures othersinto working, they may feel grateful for the direction but also may feel resentful, an-noyed, and resistant to the task.24 This sequence of events is not inevitable and maybe overcome when it leads to group success, but it occurs frequently enough to war-rant particular attention. We have also found it to be characteristic of a great manywork groups in our classes. Does it apply to your own experience?

There is yet another problem. With a few exceptions, most people have the great-est difficulty being totally honest or giving directions to those to whom they feelclosest. When someone else is emotionally close, people feel the risk is great that therelationship will be harmed by saying negative things or giving directions. Thus theyfind themselves unable to ask much of close friends. A few people, however, findthat when they build close, supportive relationships, they can be both demanding

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Falling Stars—Twilight of the Gods: CEO as American Icon Slipsinto Down Cycle

“This whole drive toward empowerment,” says Pills-bury’s [CEO] Mr. Walsh, has meant that CEOs have tocast off their big-shot image in order to communicatewith their troops. “You need to engage people on aone-on-one basis and really work hard to make them

feel part of the enterprise,” he says. “Great ideas usu-ally come from deep in the organization. They don’tcome from CEOs.”

SOURCE: Ellen Joan Pollock, The Wall Street Journal, January 5, 1999,p. A1.

MANAGERIAL BULLETIN

Conflicting Demands on Politicians

It is a horrendously difficult mandate this—to remain inthe people’s eyes (1) a down-to-earth representativewho understands them because he is one of them and(2) a leader to whom they can look up because he issomehow well above the rest of the pack in knowledge,

mysteriously endowed with superior strengths and tal-ents, a person who can be trusted to guard, to decide,to lead . . . in short, I suppose, a parent.

SOURCE: Meg Greenfield, “The ‘Just Folks’ Pantomine,” Newsweek, Oc-tober 10, 1994, p. 78.





and caring—and be cared for and receive demands in return. This kind of opennessallows closeness with subordinates without harming productivity, but it requireshigh skill and mutual commitment and probably only works where both boss andsubordinate have roughly equal expertise.

The Use and Abuse of Power

In general, it should be apparent by now that leadership can be an exciting oppor-tunity to use power or influence for getting work done; but it can be abused. Youhave undoubtedly known or heard about people in power primarily to serve theirown ends, and usually at the expense of others.

David McClelland distinguishes between personal power and socialized power, theformer referring to self-serving uses (or abuses) and the latter to uses that considerthe effects (usually benefits) on others.25 Sometimes it’s difficult to make a clear dis-tinction between the two, especially when a leader claims to be acting for the bene-fit of others yet engages in behavior that reflects anything but the best of motives.

Any act by a person in power that pressures another person to behave in waysthat violate that person’s sense of personal worth is a form of manipulation. At best,it’s insensitive; at worst, it’s a form of violence. Today’s organizations are paying in-creasing attention to these kinds of issues, including the specific problem of sexualharassment in the workplace. Laws and policies are being developed, in part becauseof pressures from the courts, that are designed to protect individuals from sexual ha-rassment in their jobs. What was once looked on as harmless teasing has come to berecognized as a humiliating abuse of power, unacceptable and unprofessional, aswell as illegal. How long it will take to educate organizational leaders and managers,university professors, and the general public to understand such abuses and take ac-tion to prevent them remains to be seen. However, it is important for you—as a fu-ture manager and as someone who will possess power—to appreciate the ethicalburdens of your job and the kinds of actions you might be required to take in livingup to those ethics.

The Opportunity to Empower Others

In the coming years, the effectiveness of leaders/managers will be measured as muchby the performance of their subordinates as by their own performance. It will bethe job of the leader—of a team, a department, or a company—to empower others to

MANAGERIAL BULLETIN

The Pentagon “Club” Closed Ranks to Shut Out Resor

Some defense officials sympathetic to Mr. Resor dofeel, however, that he contributed to his own troublesby an unwillingness or inability to deal with the petty in-trigues that are, after all, a cornerstone of any self-respecting bureaucracy.

“There was no major conspiracy to undermine Stan;it just happened, and he helped,” said one. “Youneeded someone who could go to these little empiresthat have been built up and say, ‘What are your priori-ties, what are the major issues, what are you doing?’

Stan just waited for people to come to him, and veryfew did.”

A top defense official said in exasperation: “This is avery tough place. There’s a lot of power; a lot of moneyat stake. In comes Stanley Resor—a very decent gen-tleman, somewhat old-school, not a self-serving type inany way.

“He was entirely wrong for the job.”

SOURCE: Bernard Weinraub, New York Times, March 18, 1979, copy-right © 1979 by The New York Times Company. Reprinted by permission.




perform at their best. Simple rewards and punishments won’t do the job, at leastover the long run; it will take efforts at employee involvement, shared purposes orvision, and, in general, a spirit of collaboration heretofore known in few organiza-tions. Even as you consider the situational options available to the leader, keep in

274 CHAPTER 11

MANAGERIAL BULLETIN

Unmourned Departure

“[Departing chairman of Coopers & Lybrand, EugeneFreedman] rubs a lot of people wrong,” . . . “He’s a veryaggressive person and very capable. But my guess is,there’s no love for him.”

“He’s a legend in his own mind.”According to partners and former partners, Mr.

Freedman gave himself big raises when profits flagged.They say he lived in the grand manner befitting a movie

mogul, not the head of a public accounting firm, that hesidelined rivals and surrounded himself with hordes ofminions. And they say Mr. Freedman used the power ofhis office to suit his personal agenda and to punishthose who stood up to him.

SOURCE: Alison Leigh Cowan, “Unmourned Departure at Coopers,”New York Times, January 17, 1994.

MANAGERIAL BULLETIN

Chainsaw!

He Anointed Himself America’s BestCEO, but Al Dunlap Drove Sunbeaminto the Ground

Sunbeam investors knew that Dunlap’s arrival meantthat tough medicine would soon be administered. Andat precisely 9 A.M. on Monday, July 22, 1996, whenDunlap marched into the penthouse boardroom at Sun-beam headquarters in Fort Lauderdale, the anxiousgroup of executives gathered around the table knew it,too. Dunlap wasted no time on introductions. LikeGeorge C. Scott in the movie Patton, he began by de-livering a spellbinding, if sometimes disjointed mono-logue on himself and the company. “You guys areresponsible for the demise of Sunbeam!” Dunlaproared, tossing his glasses onto the table. “I’m here totell you that things have changed. The old Sunbeam isover today. It’s over!” . . .

The men gathered around the conference tablewere stunned by Dunlap’s attack. “It was like a dogbarking at you for hours,” recalled Richard L. Boynton,president of the household-products division. “He justyelled, ranted, and raved. He was condescending, bel-ligerent, and disrespectful.” . . .

Almost all his executives believed these goals wereimpractical. Dunlap, however, refused to acknowledge

the near-impossibility of meeting them. Instead, hebegan putting excruciating pressure on those who re-ported to him, who in turn passed that intimidationdown the line. People were told that either they mettheir goals or another person would be found to do itfor them. Their livelihood hung on making numbers thatwere not makeable.

In Dunlap’s presence, knees trembled and stomachschurned. Underlings feared the torrential harangue thatDunlap could unleash at any moment. At his worst, hebecame viciously profane, even violent. Executives saidhe would throw papers or furniture, bang his hands onhis desk, and shout so ferociously that a manager’s hairwould be blown back by the stream of air that rushedfrom Dunlap’s mouth. “Hair spray day” became a codephrase among execs, signifying a potential tantrum. . . .

“I have thousands of resumes from people whowould work here for free,” Dunlap would scream,inches from his victim. “You are being paid to workhere, and you can become rich because I’ve given youall these options. And you’re letting me down. I’m work-ing hard for you on the Street, and you’re lettingme down.”

SOURCE: John A. Byrne, “Chainsaw!” Business Week, October 18,1999, p. 128. (Copyright 1999 McGraw-Hill, Inc.)




1. Leadership is mostly situational, rather than de-termined by personality traits.

2. Leadership is an influence process with subordi-nates, peers, and colleagues. Even subordinatesare not totally without influence; thus, leader-ship is net influence.

3. Influence is an act or potential act that affectsthe behavior of another person(s). Types ofinfluence:a. Formal: prescribed by office or position.b. Informal: based on expertise or charisma.c. Legitimate: influencer seen by influenced as

having the right to do so.d. Illegitimate: influencer seen by influenced

as not having the right to do so.e. Types a and b can each combine with c or d

when examining influence.4. People can be influenced through:

a. Compliance: fear of influencer.b. Identification: attraction to influencer.c. Internalization: belief in influencer’s beliefs.

5. Importance of employee commitment to:a. The work itself.b. The relationships with others.c. The organization as a whole.

6. Power is the capacity to exert influence, to makethings happen.

7. Power is based on:a. Greater legitimacy.b. Ability to enhance organization in relation

to key problems.c. Doing new activities rather than routine.d. Visibility, recognition.e. Creating obligations through helpful acts.f. Controlling rewards and punishments.g. Reducing uncertainty.

8. The greater one’s power, the more one receives:a. Communication.b. Solicitous behavior.c. Deference.d. Self-esteem.e. Close observation in new situations.

9. Powerlessness often leads to:a. Overcontrol.b. Petty tyranny.c. Rule orientation and turf-mindedness.

10. Currencies of influence.11. It is difficult for those with power to gain both

respect and liking:a. Task orientation often breeds resentment.b. Closeness to followers may constrain task

orientation.12. The use and abuse of power.13. Empowerment of others.


mind that in most cases any choice that fails to empower others is likely to be a poorone. Coercive approaches, while occasionally necessary and sometimes effective forthe short run, rarely sustain positive effects for the long run.

In the day of the knowledgeable workforce, when no single individual has a monopolyon talent and answers, good subordinateship cannot consist only of constant agree-ment with the boss. Bosses cannot afford to send in the clones; they must create, value,and work with strong individuals who have the knowledge the boss does not; and bothmust learn to blend views rather than always fight to win or compromise away strength.

David Bradford and Allan CohenPower Up

KEY CONCEPTS FROM CHAPTER 11

PERSONAL APPLICATION EXERCISE

Assessing Your Influence CurrenciesAs we pointed out in the chapter, you probably have more influence on others thanyou realize. You may not fully appreciate the behavior—“currencies”—you can offerthat are valued by friends, family members, instructors, and others. The followingexercise is designed to help you assess your currencies and thereby develop a picture




of the ways in which you influence others and how you might even increase thatinfluence.

We want you to start by identifying two people in each of three categories: (1)friends, (2) family members, and (3) instructors. (Refer to the example below as aguide.) Then list the currencies you can offer that are valued by both individuals ineach category and assign a value on a scale of 1 to 10 indicating the importance ofthat currency to each person, with the higher numbers reflecting greater importance.

You should find similarities (closer numbers) and differences (numbers furtherapart) between the individuals in a category, and you certainly should find some ma-jor differences in the currencies of the different categories. In the example, the num-bers reflect a closer friendship with B than with A, because the currencies of “caring”and “support” are more highly valued by B. In the family category, the currency thatcounts more with the father than the mother is “success,” while the opposite is truefor the “dependency” currency. In the instructor example, “listening quietly” willwork better in accounting class than in organizational behavior (OB), while the op-posite will be true for “offering opinions.”

If the example were you, can you see how your behavior could be different in thedifferent situations and in relation to the different individuals? This kind of diag-nostic process could be a valuable way for you to strengthen your interpersonalpower. It could be especially useful in a work environment, where the career stakesare high.

EXAMPLE

Friends A B Family Mother Father Instructors Acctg. OB

Caring 5 8 Love 10 8 ListeningSupport 5 10 Pride 6 7 quietly 9 4Feedback 6 6 Dependency 8 3 AskingHelp 8 6 Success 5 10 questions 7 6Knowledge of sports 2 9 Doing chores 9 9 Good work 10 10Humor 10 7 Offering

opinions 3 9

SUGGESTED READINGS

Agor, W. H. “The Logic of Intuition: How Top ExecutivesMake Important Decisions.” Organizational Dynamics,Winter 1986, pp. 5–18.

Bass, B. M. Leadership and Performance Beyond Expecta-tions. New York: Free Press, 1985.

Bateman, T. S., and S. Strasser. “A Longitudinal Analysis ofthe Antecedents of Organizational Commitment.” Acad-emy of Management Journal 27 (1984), pp. 95–112.

Bennis, W., and B. Nanus. Leaders: The Strategies for Tak-ing Charge. New York: Harper & Row, 1985.

Caro, R. The Power Broker. New York: Alfred A. Knopf, 1974.

Cobb, A. T. “An Episodic Model of Power: Toward an Inte-gration of Theory and Research.” Academy of Manage-ment Review, July 1984, pp. 482–93.

Conger, J. A. and R. N. Kanungo. “Toward a BehavioralTheory of Charismatic Leadership in OrganizationalSettings.” Academy of Management Review 12, no. 4(1987), pp. 637–47.

Conger, J. A., and R. N. Kanungo. “The EmpowermentProcess: Integrating Theory and Practice.” Academy ofManagement Review, July 1988, p. 474.

Deaux, K. “Authority, Gender, Power, and Tokenism.”Journal of Applied Behavioral Science, January–February–March 1978, pp. 22–26.

Dobbins, G. H., and S. J. Platz. “Sex Differences in Leader-ship: How Real Are They?” Academy of ManagementReview, January 1986, pp. 118–27.

Dumaine, Brian. “What the Leaders of Tomorrow See.” For-tune, July 3, 1989.

Farmer, Steven M.; John M. Maslyn; Donald B. Fedor; andJodi S. Goodman. “Putting Upward Influence Strategiesin Context.” Journal of Organizational Behavior, January1997, pp. 17–42.

Fink, S. L. High Commitment Workplaces. Westport, CT:Quorum Books, 1992.

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Gabarro, J. J., and J. P. Kotter. “Managing Your Boss.”Harvard Business Review, January–February 1980,pp. 97–100.

Gault, Stanley; Linda J. Wachner; Mike H. Walsh; David W.Johnson. “Leaders of Corporate Change.” Fortune, De-cember 14, 1992.

Heller, T. “Changing Authority Patterns: A Cultural Perspec-tive.” Academy of Management Review, July 1985,pp. 488–95.

Howell, J. P., and P. W. Dorfman. “Leadership and Substi-tutes for Leadership among Professional and Nonprofes-sional Workers.” Journal of Applied Behavioral Science22, no. 1 (1986), pp. 29–46.

Huey, John. “America’s Most Successful Merchant.” For-tune, September 23, 1991.

. “Finding New Heroes for a New Era.” Fortune, Janu-ary 25, 1993.

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Kiechel, Walter III. “The Leader as Servant.” Fortune, May 4,1992.

King, D., and B. Bass. Leadership, Power, and Influence.Lafayette, IN: Herman C. Krannert Graduate School of In-dustrial Administration, Purdue University, 1970.

Kotkin, J. “Mr. Iacocca, Meet Mr. Honda.” Inc., November1989, pp. 436–53.

Kotter, J. P. The General Managers. New York: Free Press,1982.

. Power and Influence. New York: Free Press, 1985.

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Harvard Business School Service Management Articles

Deregulation and Regulatory Backlash in Health Care

Article62 © The McGraw−Hill Companies, 2004

This article is based on my recently published book, The Corporate Practice of Medicine: Competition andInnovation in Health Care. Research support for the book was obtained from the Robert Wood JohnsonFoundation and the Milbank Memorial Fund.

Deregulation andRegulatory Backlash in Health Care

James C. Robinson

The traditional health care system, organized as a professional guild and financed by indemnity insurance, has been irrevocably changed.Once-complacent taxpayers and formerly paternalistic employers havefought back against inflating costs and escalating premiums, choking

back the once massive flow of subsidies for inefficient physician practices, frag-mented delivery systems, and cost-unconscious consumer demand. Community-rated insurance pools have fractured as self-interested and often self-insuredpurchasers pursue better value for their health care dollar. Consumers are in-creasingly assertive as to their preferences and willingness to pay for particularhealth benefits and medical interventions.

Three powerful and conflicting forces dominate the trajectory of thehealth care system. The first and most fundamental is the continuing pressure to adopt new technologies while moderating the economic burden on taxpayers,employers, and consumers. New technologies derive from a broader accumu-lation of scientific and engineering knowledge, from advances in physics, phar-macology, and pathology that highlight opportunities for intervention in themechanisms of disease, trauma, recovery, and repair. These advances do notremain under the exclusive purview of scientific or political elites but are com-municated widely to the citizenry, generating strong demands for their immedi-ate diffusion. However, this enthusiastic embrace of new clinical interventions is not accompanied by a commensurate commitment on the part of the public topay for them. The increasing wealth of society permits ever-growing investmentsin health care and it is to be assumed that expenditures will pace the overall

13CALIFORNIA MANAGEMENT REVIEW VOL. 43, NO. 1 FALL 2000



Article 63© The McGraw−Hill Companies, 2004

growth in the economy. However, even the wealthiest of nations cannot con-tinue on a trajectory that would devote 15, then 20, and then 25% of totalresources to health care. The limits on social willingness to pay manifest them-selves in the taxpayer revolt, in labor market tradeoffs between wages and fringebenefits, and in the tens of millions of citizens who lack even the most basic ofinsurance coverage.

The second feature of the emerging health care system, which derivesfrom the first, is continued innovation in forms of organization, ownership,contract, finance, and governance. Given the pressure to restrain inflation, largerewards will accrue to those who pioneer cost-decreasing products and proc-esses. Outpatient surgery, home health care, sub-acute facilities, nurse practi-tioners, inpatient hospitalist teams, practice profiling, drug formularies, casemanagers for patients with chronic illness, and internet-enabled applications of every description represent clinical innovations that attenuate rather thanaccentuate the cost of health care (compared to what the traditional hospital-centered, specialty-dominated, and indemnity-financed system would havegenerated). Each product and process faces continued pressure towards evolu-tion or extinction, but each exemplifies the process of organizational experi-mentation that has been unleashed by the transition to unmanaged competitionin health care.

The emerging corporate system of health care is better able to moderate costinflation than the traditional system of professional dominance and the onlypartially implemented systems of utility regulation and managed competition.The corporate health care system has adopted forms of organization, ownership,and contracting from the most dynamic sectors of the larger economy andapplied them to the technology, culture, and institutions of medicine. Its foun-dations lie in the multi-specialty medical groups and health insurance plans thatredesign economic incentives and clinical practice at the grassroots level. Med-ical groups, IPAs, and physician-hospital organizations offer a balance of com-petition and cooperation that accommodates the social needs for efficiency,adaptation, and innovation. Health plans have adjusted to the heterogeneity ofconsumer demand by marketing multiple networks, methods of managing uti-lization, and benefit packages priced with multiple premiums, deductibles, andcoinsurance provisions. Product diversification is accompanied by geographicexpansion, as plans and providers reduce their dependence on any one regionand leverage skills gained in one local market into competitive advantages inothers. These multi-state, multi-product firms are consolidating through mergersand acquisitions, leaving most metropolitan markets dominated by a small num-ber of large organizations. Vertical disintegration also is the norm, permittinghealth plans, medical groups and hospital systems to focus on those services theyperform best while coordinating with other services through contractual rela-tionships. Innovation in organizational structures is accompanied by innovationin contractual structures, as plans and providers experiment with new methodsof payment, medical management, and quality measurement.


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However, the long-term viability of an organizational system depends notmerely on its economic prowess, but on its compatibility with the social cultureand political institutions. In overturning so many traditional practices and ex-pectations in such a short period, corporate health care has brought down uponitself the wrath of the American populist heritage that distrusts big businessalmost as much as it dislikes big government. The third fundamental feature ofthe emerging system, therefore, is continued social discontent and political back-lash. Legislatures, courts, attorneys general, and administrative agencies haveissued a flood of hostile legislation, litigation, and regulation. Some of theseimpose beneficial supports for the corporate system, mandating grievance andreview, financial solvency, and quality monitoring mechanisms that enhanceaccountability and legitimacy. Others, however, target the very engine of inno-vation, impeding or prohibiting new methods of payment, utilization manage-ment, benefit design, network contracting, capital financing, and organizationalaffiliation.

Lessons of Utility Regulation and Deregulation

No nation has ever unleashed the forces of market competition andcorporate organization on its health care system. Insights are available from the experiences of the transportation, communication, energy, and banking in-dustries. For decades, these industries have been opened to competition and itsconsequences. Despite differences in physical technology, geographic concen-tration, and consumer demand, the experiences of the utility industries underpartial and total deregulation have been broadly similar. There is now a sub-stantial body of research from the airlines, trucking, railroad, banking, andnatural gas industries (as well as from telecommunications, electric power, andcable television). While the experiences from these sectors do not precisely rep-licate that of health care, they can provide useful guideposts and standards ofcomparison. Indeed, the utility industries are potentially more relevant to theemerging health care system than the oft-cited experiences of health care inother nations, which evolved in different cultural contexts and under differentpolitical institutions.

The deregulation of the utility industries has been remarkable for thebreadth of the industries affected and the depth of the changes effected, but alsobecause it was so unanticipated. Scholars and industry observers have divergedwidely in their assessment of the economic desirability of regulation but con-verged in their assessment of its political durability. Liberals often interpretedregulation as an efficiency-enhancing response to market failure and as anequity-enhancing means of subsidizing the poor. Conservatives often denouncedutility commissions as captured by the regulated industries, and hence as con-ducive to inefficiency and inequity, but by this very token despaired of mobil-izing a political constituency for change, since the beneficiaries of regulation are concentrated and committed while the losers are dispersed and apathetic.


CALIFORNIA MANAGEMENT REVIEW VOL. 43, NO. 1 FALL 2000 15




However, over the course of the 1960s and 1970s, during the era of its apparentinvincibility, utility regulation was subjected to a sustained critique from boththe left and the right that created an intellectual quasi-consensus and preparedthe way for sweeping change in the following decades.

The new consensus, shared in diverse ways by consumer activists andNobel laureates, by Democrats and Republicans, is that utility regulation ex-acerbates rather than attenuates economic inefficiencies and social inequities.The inefficiencies stem from incentive distortions induced by particular rules and from the general climate of a protected, non-competitive industry. Regula-tory pathologies were identified in the airline industry, where price floors stimu-lated cost-increasing competition through amenities and flight frequency;1 in theelectric power industry, where rate-of-return limits induced a substitution ofcapital for labor and the construction of overly large generating facilities;2 in therailroad industry, where restrictions on track abandonment led to excess capac-ity, under-maintenance, and demands for public subsidy;3 in the banking indus-try, where constraints on product and market diversification limited the numberand type of financial instruments and protected inefficient and poorly managedfirms;4 and in the natural gas industry, where uniform rates prevented conserva-tion-enhancing seasonal and time-of-day pricing.5 Barriers to market entry,product diversification, and corporate mergers protected incumbent firmsagainst the rigors of competition, fostered managerial slack, financed above-market wages, and discouraged innovation in methods of production, supply,and marketing. The distributional impact of regulation derives from its attentive-ness to mobilized political constituencies and its insulation from the larger butless vocal majority. Simplistic theories of agency capture by regulated industriesfailed to acknowledge the full complexity of regulatory politics, in which con-sumer groups, legislators, and litigators all play important roles, but did succeedin dispelling even more simplistic interpretations of regulation as a means to taxthe rich and help the poor.6 The greatest defenders of continued regulation oftenhave been not the disenfranchised but the regulated firms themselves, backed bytheir investors, bankers, labor unions, executives, and employees.

Deregulation is not a one-time event but a process that unfolds in differ-ent ways across industries and geographic markets. It generates instability andstress, and it is threatened continually by political reaction and re-regulation.Based on the industry experiences and research evidence to date, four basicimpacts can be identified.7 First, deregulation in the utility industries has stim-ulated productivity and performance, with significant reductions in cost andimprovements in service. Second, it has led to differentiation among productfeatures and prices depending on the purchaser, the geographic market, the sea-son, and other characteristics of supply and demand. Third, the relaxation ofrestrictions on new entry has led to dramatic changes in market structures, orga-nizational forms, distribution networks, and methods of purchasing. Finally, de-regulation has engendered countervailing pressures to slow the pace and reversethe direction of change, to dampen the instability and impede the innovation, to






cushion the blow to previously favored constituencies, and in some cases to re-regulate in whole or in part the behavior of the industry.

Utility Deregulation: Cost and Quality

The most visible impact of deregulation has been to lower prices andimprove service to consumers.8 After adjusting for economy-wide inflation,deregulation has reduced fares per mile traveled by 33% for airlines, 35% forless-than-truckload freight, 75% for full-truckload shipping, and 50% for rail-roads. Natural gas prices have fallen 30% for both residential and industrialusers. Service frequency has increased substantially in air transportation, due to lower fares and higher demand; service times have declined substantially forless-than-truckload and full-truckload shipping; both the mean and standarddeviation of railroad transit times have fallen by approximately 20%; banking is more convenient due to longer hours, automatic tellers, no restrictions onbranching; and natural gas service is more reliable as shortages have beeneliminated.

Higher value to the consumer has derived from improved industry pro-ductivity, capacity utilization, and network configurations and from a virtuouscycle of lower costs, lower prices, increased demand, and further reductions incosts. The hub-and-spoke route configuration developed by the deregulatedairline industry has raised rates of seat occupancy from 52% to 62% and therebylowered costs per mile flown by 25%. Price wars have driven down air fares,dramatically increased business and leisure air travel, and permitted ever morefrequent flights.9 The trucking industry has increased the percentage of fulltruckloads and reduced the number of empty return miles, thereby permittingprice reductions that have attracted additional business from non-trucking firmsthat previously shipped on their own vehicles to avoid the costs of trucking reg-ulation. Railroads have abandoned approximately one-third of their trackage,reduced operating costs, improved profitability, and thereby escaped from theregulation-induced death spiral of mandated excess capacity, high operatingcosts, high prices, declining demand, and need for ever-greater subsidy. Bankshave lowered their operating costs through extended electronic and branchbanking, raised interest rates above regulatory ceilings, and developed newfinancial products that better balance risk and return. Natural gas firms haverestructured their transmission and distribution networks and improved pipe-line capacity utilization, reducing overall operating and maintenance expensesby 35%.

Utility Deregulation: Price and Product Differentiation

A common characteristic of utility regulation was uniformity in prod-ucts and prices in the face of great variability in consumer preferences and the actual costs of providing service. This one-size-fits-all approach led to ser-vices that were of excessive cost for some consumers and insufficient quality forothers, impeded the use of price flexibility to enhance capacity utilization, and






juxtaposed overcapacity and low load factors in some industries with underca-pacity and shortages elsewhere. It generated cross-subsidies from consumers for whom the cost of service was low to consumers for whom the cost of servicewas high. Shippers on heavily traveled routes subsidized shippers on remoteroutes and long distance telephone users subsidized local callers.

Deregulation has spurred an outpouring of new services that incur differ-ent costs and impose different prices, permitting a better match between supplyand demand. Air travelers can obtain substantial discounts if they purchase tick-ets in advance and stay for the weekend, but must pay the full cost of standbycapacity if they want to delay their decisions to the last minute. Shippers canobtain low rates if they allow their freight to be combined with others’ and berouted over less direct but more heavily traveled corridors, or they can choose topay the full cost of less-than-truckload delivery. The increased variability in priceand service results in part from the deregulation of contracting between buyersand sellers. Rail and road regulation, for example, often prohibited shippers fromnegotiating with transporters for volume discounts, flexibility factors, multi-market or multiyear agreements, or other variations from uniform price andservice standards. Now half of rail freight moves at specially contracted rates,allowing better track utilization for the railroads and better coordination of pro-duction, inventory, and distribution for the shippers. Deregulation permits thecontractual flexibility that allows buyers and sellers to explore potential gainsfrom new electronic and Internet technologies, thereby accelerating the adop-tion and diffusion of innovation.

Utility Deregulation: Market and Organizational Structures

Deregulation stimulates competitive entry into previously protectedindustries and local markets. Startups challenged the most prominent firms in airlines, trucking, electric power, and telecommunications and even haveappeared in specialized niches of the railroad industry. After an initial turbulentphase, however, deregulated industries undergo a process of concentrationthrough merger, acquisition, market exit, and bankruptcy. Airlines, railroad, andbanking firms are almost all larger now than prior to deregulation, and there hasbeen a similar wave of consolidation in the electric power and telecommunica-tions sectors. Deregulation has spurred exit from particular product and geo-graphic markets as firms have pulled out, sold out, or gone under in the face of new entry. Much of this was overdue, since regulation protected incumbentsfrom more efficient and innovative outsiders. Large scale is not incompatiblewith the most intense competition, as much growth has occurred throughproduct and market diversification.

Some firms have grown by developing broader networks that better fitthe needs and preferences of customers. Airlines have thickened their regionalnets by servicing more communities around their hubs and have developed jointventure and contractual arrangements to service global demand. Railroads havemerged end-to-end to more efficiently link ports to mines to manufacturing






centers, and have purchased or contracted with maritime shipping firms andtrucking companies to offer intermodal transport services. Many mergers andacquisitions are designed to penetrate new geographic markets, as in branchbanking and local service telecommunications, or to penetrate new productmarkets, as in linkages between commercial banks and investment banks. Sub-stitution stimulates rivalry for traditional services and their producers. Mutualfunds, corporate lenders, life insurers, and other financial intermediaries nowcompete with savings and loan institutions for deposits. Of course some consoli-dation is designed to reduce rather than increase competition. While end-to-endmergers increase rivalry in the railroad industry, parallel mergers decrease it.Airlines dominant at particular hubs can exploit the shortage in airport capacityto exclude rivals and raise rates. All in all, however, the utility industries havebecome increasingly competitive as the deregulatory process has unfolded, evenin what were formerly considered natural monopolies such as electric powerand telecommunications. The strategy of full service diversification—driven bythe heterogeneity of preferences, technology, and geography—leads to the cre-ation of large firms competing fiercely across many products and many markets.

Utility Deregulation: Political Backlash

Deregulation has exerted a major impact on the political climate of theutility industries, in some cases stimulating a backlash that finds sympatheticears in legislatures and the courts. Formerly subsidized consumers deplore mar-ket-level price and quality. Airline pilots, unionized teamsters, stock brokerscharging fixed commissions, employees of power companies with cost-plus ratestructures, and domestic crews on American flagships all have experienced thereduction in industry costs as a reduction in personal incomes. Consumers as awhole are winners, with more choices, better service, and lower prices, but sig-nificant subgroups find themselves to be losers. Everyone appreciates pricedecreases and quality increases in services where regulation offered neither sub-sidy nor shelter. They lament, however, similar effects in industries where theywere protected and pampered.

The consumer and producer backlash against utility deregulation hasfound sympathetic ears in Congress, state legislatures, and executive agenciesdue to the structure of political incentives and institutions. Legislators look notto the aggregate social impacts of deregulation but to the costs and benefitsaccruing to their local constituents. They seek to slow, stop, and reverse adverseimpacts, such as the abandonment of little-used railroad trackage, competitivethreats to hometown truckers, and the transfer of jobs to distant communities.Elected politicians and appointed administrators are concerned with short-runrather than long-run effects and are uncomfortable with the instability createdas deregulation opens long-protected industries to entry and innovation. Allthree branches of government are under continual pressure to do no directharm, to minimize adverse impacts on the visible and vocal at the expense of






the invisible and inarticulate, thereby upholding perceived standards of dueprocess while rewarding politically powerful interests.

The process of deregulation has generated considerable friction, butalmost without exception it has not been reversed. Indeed, the deregulatoryprocess has spread to previously untouched industries and previously uncon-vinced nations, as local phone service sees the first glimmerings of competition,global maritime and airline regulations are loosened, and European nations re-examine their telecommunications and transportation policies. Over time, more-over, deregulation creates a constituency in its own support, as producers,consumers, and communities advantaged by the changes mobilize against re-regulatory initiatives. Nevertheless, the process is fragile and always endangered.Utility deregulation depends on the political as well as the economic market-place, on the temporal and geographic incidence of costs and benefits, on thecomparative salience of winners and losers, and on the likelihood that politicalentrepreneurs will find in the turbulence of change the opportunity to pursueother agendas.

Comparing Health Care to the Utility Industries

No exact analogies can be drawn between the changes sweeping throughhealth care and the revolutionary transformations spurred by deregulation inthe transportation, communication, energy, and finance industries. Health carewas never subjected in such an explicit and comprehensive fashion to the dic-tates of a utility commission. However, the performance of the traditional healthcare system so closely resembled a regulated utility, and health care competitionhas affected performance in ways so similar to utility deregulation, that signifi-cant commonalities must be acknowledged and important lessons can belearned. Many states experimented with price controls covering a subset ofinsurers, and all imposed certificate-of-need entry barriers for at least some ser-vices and facilities and a few states imposed rate regulations affecting all hospitalpatients. The Medicare program imposed a uniform administered pricing systemfor its patients on the nation’s hospitals, and many states imposed Medicaid pay-ment rates that were based on budgetary politics rather than an analysis of thecost of care.

Economic theory looks to market failure and income redistribution toexplain the pattern of regulation and deregulation across industries. The mostcommonly cited market failures include natural monopoly (which can lead toexcess profits and distortion of resource allocation) and imperfect information(which can expose consumers to exploitation by better-informed producers).Distributional motives include the efforts by producer or consumer groups toconvince legislators and regulators to impose taxes, rules, or other mechanismsthat generate special benefits for special interests. Health care includes ruralcommunities too small to support more than one hospital or a few physicians,but the mainstream of the system is structurally so competitive and has so






many providers that it is implausible that public policy can be an efficiency-enhancing response to natural monopoly. Imperfect information is a moreimportant feature of health care and one to which has been attributed most ofthe system’s unusual organizational and normative characteristics.10 It is difficultto believe, however, that the asymmetry of health care information betweenconsumers and producers has changed in an exogenous fashion over the pastthree decades and thereby spurred the tumultuous changes in ownership,finance, and payment mechanisms. The amount of health care information pos-sessed by consumers is likely to be the result rather than the cause of changes inthe economic and political environment. It therefore is most enlightening toexamine distributional motives, cross-subsidies, and the creation of rents as theunderlying source of similarity between the processes of regulation and deregu-lation in health care and the utility industries.11

Many of the traditional institutional and normative features of healthcare served to restrict entry, comparison-shopping, price competition, and otherfeatures of a deregulated industry.12 Professional licensure, judicial acquiescencein physician boycotts of prepaid group practice, and exemption from antitruststatutes created economic rents for physicians that could be spent providingcharity care for the indigent or by enjoying a more generous personal lifestyle.State “corporate practice of medicine” statutes outlawed the creation of verti-cally integrated delivery systems that would employ physicians to provide ser-vices on a salaried basis. “Any willing provider” statutes prevented insurancecompanies from negotiating volume discounts with subsets of physicians, phar-macies, or other provider entities. Community-rating regulations limited theability of insurers to offer low premiums to healthy subscribers, thereby increas-ing revenues potentially available for subsidizing premiums for unhealthy sub-scribers. Hospital rate regulation programs directly imitated utility commissionpricing policies, imposing price floors as well as ceilings to generate the operatingsurpluses necessary to subsidize charity patients. Certificate of need regulationslimited entry and dampened the non-price competition that would dissipateoperating surpluses. A particularly important feature of the health care industry,less prevalent in the utility sector, is the moral hazard generated by widespreadinsurance. Indemnity and Blue Cross insurance buffered consumers from thecost consequences of the physicians’ decisions and thereby fueled an open-ended demand for quality-improving and service-enhancing new technologiesand process of care. Certificate of need and rate regulation in the hospital indus-try was consciously designed to moderate the inflationary aspects of this “med-ical arms race,” in a manner analogous to that of the Civil Aeronautics Board inits campaign against amenity competition and low load factors in the airlinesindustry. Some of the competition-limiting features of the health care systemwere designed in part to effect the spreading of insurance risk and subsidy of the ill through indirect means, as an alternative to creation of a national healthinsurance system analogous to those in European nations. Here again the healthcare system bears comparison to the utility and transportation industries, which






were put under regulatory tutelage during the New Deal era in part to forestalldemands for nationalization on the then-prevalent European model.

Most economic discussions of the politics of deregulation focus on thetendency for the cross-subsidies underlying utility regulation to grow over timeand to become ever more complex and unpredictable in incidence. Thesechanges gradually undermine the political support for the regulation, creatingnew coalitions that eventually accumulate sufficient power to partially or com-pletely remove the regulatory edifice.13 The accelerating medical care inflation of the 1970s and 1980s spurred the principal purchasers of health care, includ-ing private employers, state Medicaid agencies, and the federal Medicare pro-gram, to attack the institutional barriers to competition in health care. Theremoval of the antitrust exemption, abandonment of most Certificate of Needand hospital rate-setting programs, and removal of limits on price-based nego-tiations between insurers and providers embody experiments in moving thehealth care system towards a more competitive market. The phenomenonknown as managed care—comprising various combinations of volume purchas-ing (“selective contracting”), prepayment (“capitation”), monitoring and over-sight (“utilization management”), creation of preferred provider panels, andother mechanisms—attempts to limit moral hazard and stimulate cost-consciousdecision making.

Health Care: Cost and Quality

Market competition and corporate organization have demonstrated aremarkable ability to moderate the inflationary trajectory.14 The development of medical groups, health care systems, multi-product insurers, capitation con-tracting, and utilization management during the 1990s held the growth inhealth care costs to the lowest levels in 50 years, confounding the skeptics andcontributing to the strong economic performance of the decade. It is difficult toascertain the influence of corporate organization on health care quality, due tothe inherent difficulties in measuring outcomes and to the lack of pre-existingbaselines for comparison. The overall quality of care is improving, but this is dueprimarily to longer trends in laboratory research, physician training, and tech-nology diffusion than to recent changes in markets and organization. The recordon customer service is decidedly mixed. Cost pressures have led to a shorteningof physician visits and oversight of utilization patterns that patients resent, whilethe new emphasis on satisfaction surveys and enhancement has induced provid-ers to offer longer office hours, 24-hour telephone advice, and other consumerconveniences.

The short-term success against health care cost inflation does not implythat the long-term battle for stable expenditures has been won. On the contrary,America is poised to enjoy the clinical benefits but rues the budgetary implica-tions of an outpouring of new drugs, devices, tests, and treatments that preventinfection, dispel uncertainty, enhance functional ability, and generally contributeto a healthier and more long-lived citizenry. This technological dynamic opens






diagnostic and therapeutic opportunities that are hard to ignore, but it is lessimportant perhaps than the revolution of rising expectations. It is clear that asthe population gets healthier, it demands more—not less—from its medical caresystem. We embrace treatments for old ailments that once were merely suffered,from childhood viruses and rashes through migraine headaches and springtimeallergies to the impotence and arthritis of our golden years. We open our heartsand our wallets to medical breakthroughs that benefit victims of the greatscourges of our time, from childhood cancer through AIDS to Alzheimer’s. Wetake gains in longevity for granted, expect that full physical, social, and intel-lectual functioning will continue to the now more distant end, and insist thatthese advances are for all to share.

The corporate system of health care does not seek to stop the develop-ment of quality-increasing technology or to quell the revolution of consumerexpectations, both of which inevitably accompany the growing wealth of society.It does, however, create significant changes in economic incentives and organi-zational structures that will temper the rate of inflation and enhance the overallvalue of health care services in a manner analogous to the gains in efficiencyand quality in the deregulated utility industries. Four dimensions are particularlyworthy of note.

The shift from the professional guild to integrated organization, fromindemnity insurance to managed care, and from non-price rivalry to price com-petition creates strong economic rewards for the diffusion of cost-decreasingclinical innovations. The medical arms race rewarded the development of tech-nologies that raised quality—real or perceived—but not ones that reduced costs.Now firms and individuals at every point along the health care value chain—from bench scientists to clinical researchers, pharmaceutical manufacturers,hospital managers, multi-specialty medical groups, single-specialty networks,and primary care physicians—can increase their status and income if they dis-cover, develop, or adopt interventions that reduce the overall expense of care.

The corporate system is rapidly restoring the normal economic relation-ship between supply and demand, between market disequilibrium and pricechanges in health care. The United States has inherited an excess supply of acutecare hospitals and physician specialists, analogous to the excess capacity gener-ated by entry and exit regulation in many utility industries. In the now-passingsystem of guild organization and indemnity insurance, excess capacity stimu-lated cost-increasing non-price competition analogous to that experienced bythe rate-regulated airline industry. Health services researchers delighted in dis-covering ever-new economic pathologies, from Roemer’s Law that a built bed isa filled bed, to the medical arms race of duplicative clinical technology, to sup-plier-induced demand in response to physician fee reductions. Henceforth, facili-ties and services that are in excess supply will receive lower, rather than higher,prices than otherwise comparable facilities and services that enjoy excessdemand. The painful recalibration of relative incomes within the profession






and across the industry will continue, redirecting investments and career choicestowards areas of need rather than areas of excess.

The original demand placed on the corporate system by public and privatepurchasers was to reduce the cost of care, not to improve quality and service,and the system responded accordingly. The greatest emphasis in the early yearshas been on methods of payment, network contracting, utilization management,benefit design, and organizational structure that promise to restrain the infla-tionary spiral. Considerable success has been achieved in this endeavor. How-ever, the distinctly American question remains: What have you done for melately? Patients are worried lest the emphasis on cost control reduce the qualityof the care they receive. Consumers are annoyed with every obstacle to obtain-ing what they want when they want it. The corporate system is shifting itsemphasis to developing methods for measuring and improving service, in amanner analogous to the process pursued in the utility industries after deregula-tion. For the first time, the health care industry is being subjected to systematicmonitoring of quality and service levels, with the intent of promoting clinicalcomparisons and quality-conscious consumer choice. The road to be traveled in a difficult one, since almost all the monitoring tools need to be invented. Asalient feature of the professional guild was reliance on unmonitored trust andopposition to quantitative, validated measures of performance. Purchasers,plans, and provider organizations now experiment with satisfaction surveys,indicators of preventive services utilization, tracers for appropriate clinicalprocesses, and risk-adjusted measures of patient outcomes. The new monitoringmechanisms hold great potential to enhance as well as simply measure the qual-ity of care, since statistical and epidemiological methods always outperform bad-apple approaches to quality improvement.

Deregulation has not universally improved quality and service in the util-ity industries. We all bemoan the paucity of empty seats on the airlines or theubiquity of small fees for banking services that once were offered free. Someforms of regulation imposed a uniformly high-cost, high-quality style of serviceby forbidding firms from developing economy options. Without the ability toattract customers through lower prices, airlines added flights that they knewwould be half-empty and financial institutions offered white-glove service tothose customers who could come in during bankers’ hours. Deregulation inthese contexts led initially to a reduction in service as a byproduct of an evengreater reduction in price. However, the value offered to the customer, definedas including both service and price, increased. Most of us are willing to put upwith strangers in adjacent seats in order to obtain economy fares and, for thosewho are not, the airlines offer business class service. Similarly, the corporatesystem of health care will experiment with different combinations of price andservice to find the mix that offers best value in the mind of the consumer. Thereare tradeoffs to be made between broad and narrow provider networks, strin-gent and loose utilization management, thick and thin benefit coverage, highdeductible and first dollar cost sharing, and, of course, between connoisseur






class and economy prices. The tradeoffs are more controversial in health carethan in the utility industries since the benefits of gold card service accrue to thepatient while the benefits of low cost often accrue to the employer or taxpayer.

Health Care: Price and Product Differentiation

Generations of reformers have sought to overcome the variability inhealth care demand and supply through uniform benefits, premiums, and pricesthat do not vary according to incomes, preferences, health, location, employ-ment, or other characteristics of consumers and producers. In the absence ofstrong governmental controls, however, the heterogeneity among consumers (in what they are willing to buy) and among providers (in what they are willingto sell) is driving price and product differentiation in health care. Benefit cover-age and network design, premiums and prices, and method of marketing anddistribution now are highly variegated and promise to become ever more so.

The defeat of President Clinton’s Health Security Act spelled the demise of the uniform benefit package as the foundation of health care policy in theUnited States. Simply put, those who currently enjoy rich benefits and low pre-miums—due to good subsidies, good health, or good luck—are unwilling to sac-rifice so that the less endowed, less healthy, or less fortunate can come up totheir level. A uniform benefit package sufficiently rich to be politically accept-able to the quality-conscious voter would be economically unacceptable to thecost-conscious taxpayer. The unstandardized marketplace is responding to thediversity in incomes and preferences though a wide variety of benefit packages,cost-sharing provisions, network configurations, and methods of utilizationmanagement. Self-employed individuals and small firms now can shop from amenu of options—with inclusion, exclusion, or partial coverage for prescriptiondrugs, mental health services, rehabilitation therapy, and complementary medi-cine; with different levels of cost sharing; and with combinations of deductiblesand co-payments for particular services. Large public and private purchasersdemand idiosyncratic benefit configurations, reminding the health plans andproviders that he who pays the piper calls the tune. Network designs are pro-liferating at an equally astonishing rate, mixing and matching PPO and HMOcomponents, gatekeepers and self-referral, prior authorization and retrospectiveprofiling, out-of-network wraparounds and out-of-area expansions. The three-letter acronyms that once anchored our understanding of health insurance alter-natives are rapidly becoming untethered as the industry crafts hybrid strains in a dizzying display of product-engineering.

Premiums and prices have lost whatever uniformity they once possessed,with community-rating and standard methods of capitation and fee-for-servicebeing swept aside by the market imperative to vary prices according to underly-ing variations in costs. Consumers choosing rich benefit packages, loose networkdesigns, and patrician physician practices find themselves paying substantiallymore than those content with thinner benefits, more tightly managed access,and community-based practitioners. Public and private sponsors are continuing






their slow and painful transition from defined benefits to defined contributions,paying a fixed dollar amount rather than encouraging costly choices throughhigher subsidies. In a competitive market each product must be priced to be self-supporting, since cross-subsidies invite new entry that appeals to the over-charged customers. The diverse options in benefit and network design arereflected in actuarially sound, and hence diverse, price levels. Insurance premi-ums and provider payments will increasingly reflect the health status and cost of care required by the individual enrollee and patient. Risk-adjusted prices aredesirable since they remove incentives to cherry-pick the healthy and avoid theill. They are essential for the continued economic viability of safety-net providerswho attract the sickest patients due to their geographic location or open-doorpolicy. In the absence of risk-adjusted subsidies, market competition will shiftthe economic burden of illness onto the ill while allowing the healthy to pay foronly their modest medical needs. The United States currently maintains a tat-tered fabric of risk-adjusted subsidies, with employer-paid benefits, governmententitlement programs, and the health insurance tax deduction allocating greatersums for sick than for healthy citizens. However, the system has many loopholesand exceptions. Competitive markets and corporate organizations in health carewould benefit from a well-designed and well-financed system of risk subsidies,since this would eliminate the pressure to deny coverage and would convertcharity cases into paying customers. However, steps in this direction are difficultsince they would violate the ban on new taxes, which is one manifestation ofthe “do no direct harm” principle in contemporary politics.

The marketing of health care is increasingly differentiated and methods of branding, distributing, and selling are becoming key competitive skills forhealth plans and provider organizations. It is increasingly hard to imagine thatall Americans one day will pick up their health insurance at the local SocialSecurity office or be channeled through a uniform open enrollment process.Consumers obtain their information and options through insurance brokers and websites, private and public employers, state insurance pools and Medicaidagencies, federal Medicare and military programs, and myriad other options. Theindustry is pioneering ever-new ways of connecting buyers and sellers, includingprint and electronic media, direct mail and the Internet, community organiza-tions and consumer cooperatives. Through it all, the American consumer reignssovereign over a complete menu of choices, chaos of opportunities, and cacoph-ony of salesmen promising a product as unique as the individual and as afford-able as the alternative.

Health Care: Market and Organizational Structures

We are witnessing massive changes in the structure of health caremarkets and organizations. Many of today’s most prominent organizationalforms, such as Independent Practice Associations and physician-hospital organi-zations, were difficult to find 20 years ago.15 Multi-specialty medical groups havea long and illustrious history in some communities but have been thoroughly






transformed by the marketplace shift towards managed care. Preferred providerinsurance has displaced indemnity and the network HMOs have displaced theirstaff model progenitors only in the recent decade. Forms of contracting are in a state of ferment, with payment methods that borrow from both capitation and fee-for-service and methods of utilization management that compromisebetween arm’s-length review and full delegation. Organizations are becominglarger and more complex through merger, acquisition, and product diversifica-tion. However, increased scale is stimulating competition rather than cartels, as local barriers fail to impede entry by multi-product, multi-market firms.

The most visible feature of the corporate system of health care is ceaselessacquisition and divestiture, integration and outsourcing, and combination andrecombination. Medical groups, hospital systems, and health plans are comingtogether and then coming apart, substituting contract for joint ownership, creat-ing diversified conglomerates and refocused facilities, and experimenting withever new structures of ownership, finance, governance, and management. Afterdecades in which medicine was frozen into a cottage industry of solo physicianpractices, freestanding community hospitals, and single-state Blue Cross insur-ers, incumbents and upstarts are pushing boundaries in ways once not merelyinfeasible but unthinkable. They are exploring potential economies of scale, theadvantages offered by large size in insurance risk bearing, administrative effi-ciencies, and vendor contracting as well as the diseconomies that accompany theattenuation of individual incentives and accentuation of influence politics. Firmsare exploring the economies and diseconomies of scope, the tradeoffs betweenconglomerate versus staff-and-line organization, broad-spectrum versus nichepositioning, transfer versus market pricing, diversification versus product focus,coordination versus clinical specialization. They seek some middle groundbetween the extremes of vertical integration and spot contracting, some balanceof coordinated and autonomous adaptation in the face of ever-new challenges.

This process of trial and error is generating a diversity rather than unifor-mity of organizations and contracts. The heterogeneity of regional providers andpurchasers, technologies and transactions, economics and demographics, popu-lar cultures and political institutions supports an enduring variety in the healthcare marketplace. There are striking cross-market and within-market differencesin methods of payment, medical management, data reporting, and qualityaccountability. Some physician communities are characterized by multi-specialtymedical groups, others by more loosely structured IPAs, and others by a continu-ing Diaspora of unaffiliated practices. For-profit hospital chains hold a strongposition in some communities, while others are dominated by large nonprofitsystems and the remainder cling to hometown facilities. Different regions favordifferent mixes of HMO, PPO, and hybrid insurance products. This heterogeneitystems both from enduring regional characteristics and from transient differencesin each community’s place on the health care learning curve, as experimentsthat succeed in one locality are copied in others.






Medical groups, hospital systems, and health plans want to avoid therigors of competition by acquiring or merging with their rivals, seeking oligopolyand ultimately monopoly power to dictate prices and protect profits. However,accomplishment seems ever to lag behind aspiration, as purchasers, suppliers,substitute services, and entrepreneurial outsiders compete for their share ofthose potential monopoly profits. The organizational diversification of healthplans and providers has created a ravenous crowd of well-financed and battle-hardened competitors able to jump into new products and new markets whenrevenue opportunities arise. Entry barriers are lower, not higher, than in thebygone era when the professional guild boycotted group practices, fixed prices,restricted advertising, enforced any-willing-provider laws, and banned the cor-porate practice of medicine. The cottage industry structure of yesteryear lentitself well to the most thoroughgoing anti-competitive practices, while the largecorporate organizations, consolidated industry structures, and complex contrac-tual relationships of today lend themselves to the most vigorous competitionever observed in health care.

Health Care: Political Backlash

The political backlash against competitive markets and corporate organi-zation in health care has far exceeded the reaction against deregulation in theutility industries. The success against cost inflation has produced large savingsfor employers and governmental programs but little visible benefit to individualemployees and taxpayers. Had the rate of inflation that prevailed in the fiveyears prior to the defeat the President Clinton’s Health Security Act continuedfor the five years following that landmark event, health care costs and premiumsat the end of the decade would have been twice their actual levels, creating direpersonal hardships, acrimonious tax politics, and contentious labor relations.However, the transition to a market-driven health care system coincided with an acceleration of trends away from paternalistic employment policies and wel-fare state politics. Many employees experienced the decline in overall premiumsas an increase in their paycheck deductions and compared unfavorably the net-work restrictions and utilization oversight of managed care with the halcyondays of first dollar indemnity insurance.

Consumer concerns have been accompanied and encouraged by a pro-ducer backlash against the changing market and organizational structures inhealth care. Hospital employees and their labor unions are dismayed to note the shift in jobs from unionized inpatient settings to often nonunion ambulatory,sub-acute, and home health settings. Medical specialists resent the tilt in statusand income towards primary care. Physician earnings have continued to rise,but at a slower pace and in a much more uneven pattern than in the era of cost-unconscious consumer demand. Medical groups and hospital systems impose adegree of administrative oversight, peer review, and public accountability thatfeels foreign and uncomfortable to clinical miracle-workers. Caregivers resentthe budgetary constraints necessary for financial solvency as unwarranted






incursions on their clinical autonomy. Specialty societies, labor unions, devicemanufacturers, and all the other constituents of the medical-industrial complexhave mobilized in defense of their economic self-interest, naturally explainingtheir behavior as a defense of patient rights and the quality of care.

The number and variety of new laws and regulations concerning thecorporate health care system is remarkable. While debate over the federal legis-lation (including imposition of liability on insurance plans and exemption ofphysicians from antitrust law) has gained the greatest attention, most of theactivity has been at the state level. In the 1999-2000 legislative session, over10,000 pieces of health care legislation were introduced at the state level.16 Forexample, 38 states imposed timelines on claims payment, 31 mandatory disclo-sure of pharmacy formularies, 27 banned various payment incentives for physi-cians, 21 required insurers to include “any willing provider” in their contractualnetworks, 19 mandated “point of service” options on HMO products, 7 imposednew tort liability on insurers, and one exempted physicians from state antitruststatutes. The numbers rise rapidly when bills are counted that did not reach thegovernor’s desk, including 21 state bills to exempt physicians from antitrust lawand 32 state bills to increase insurer tort liability. Needless to say, measures ofregulatory backlash that include regulations in addition to new statutes wouldbe substantially larger.

Social Benefits of Partial Re-Regulation

Market economies need well-conceived and well-implemented politicalinstitutions just as much as democratic polities need vibrant economic markets.Utility commissions and statutory compulsions were not replaced by laissez fairein the transportation, communications, and finance industries but by a mix ofdisclosure mandates, safety standards, financial reserve requirements, and othersafeguards that protect the public interest with a hand somewhat less visiblethan before. By analogy, some mechanism of oversight and accountability arebeneficial and indeed essential for the corporate system of health care.

A salient characteristic of medicine is the clinical uncertainty of each indi-vidual’s diagnosis and appropriate treatment. It is essential that administrativelyefficient and socially acceptable mechanisms be developed for reviewing, adju-dicating, and appealing differences concerning benefit coverage, experimentaltreatment, and medical necessity. These mechanisms must be not only suffi-ciently close to the clinical interface to produce informed and timely outcomes,but sufficiently independent to claim a broader legitimacy. The system will needto grope to some workable mix of mediation, arbitration, and litigation toresolve differences in what is an inherently stressful and complex decision-making arena.

Health insurance involves the collecting of premiums and subsequentpaying of claims in a manner that invariably raises the possibility of over-extension and insolvency. State insurance departments traditionally regulated






indemnity, Blue Cross, and HMO carriers but have been outstripped by the geo-graphic expansion, product diversification, and capitation contracting of theindustry. The locus of administrative control and the incidence of risk is nolonger clear in health plans that operate in multiple states, offer multiple net-work designs, and sell every form of insurance, partial insurance, and reinsur-ance. Private employers and public agencies with self-insured fringe benefitsprograms escape state regulatory oversight altogether. Medical groups, practicemanagement firms, and physician-hospital systems cover capitated populationslarger than the enrollments in some insurance companies yet are often exemptfrom formal insurance regulation. The emerging system needs to revisit the nutsand bolts of tangible net equity, liquidity ratios, and other means for ensuringthat the money paid at the beginning of the year is still available to cover thestream of claims that trickle in at the end.

The emerging health care system has pioneered new methods for thecollection, dissemination, and comparison of data on customer service andclinical quality. The progress to date has been frustratingly slow but has laid the foundation for more specific, severity-adjusted, and outcomes-orientedmeasures in the future. This is an arena with important roles for public agenciesthat can mandate participation, for nonprofit organizations that can develop theinstruments, and for health plans and providers who can cooperate on data col-lection and compete on quality results. The proliferation of print, television, andinternet avenues for the dissemination of quality and service data repeats theexperience of the deregulated utility industries, where the rise of choice andcompetition created a new demand and thereby spurred a new supply of infor-mation to consumers.

The Corporate Practice of Medicine

The corporate system of health care has produced ever-larger organiza-tions and ever more intense performance competition among them. However, itssustainability has not thereby been assured. The very dynamism of the corporatesystem disrupts established social norms and disadvantages powerful politicalconstituencies. American health care will never go back to professional domi-nance, which lost its political power as well as its organizational basis in thetransition to managed care. It will not proceed to the complete consolidation,the full vertical and horizontal integration embodied in the principles of man-aged competition. However, corporate health care is threatened by a new formof regulation. This will not be the entry barriers and rate setting of the utilitycommission, but will come through myriad small rules, requirements, and judi-cial precedents designed to protect the purportedly helpless consumer againstthe hazards of choice and competition. Individually, each new regulation willlimit only modestly the discretion of health care purchasers and providers.Cumulatively, however, they could strap down the corporate Gulliver through






a thousand small impediments on innovation, taxes on efficiency, and litigiousdisputes over clinical uncertainties.

Despite the serious challenges facing the emerging health care system, itis possible to conclude on a cautiously optimistic note.17 Political backlash fol-lowed the growth of large diversified firms in the American economy but did notreverse its course, due to the remarkable gains in efficiency and quality gener-ated by market competition and corporate organization. Capacity investment,market entry, product price, and service specifications have been opened tocompetition in the transportation, communication, energy, and finance indus-tries after decades of utility regulation. The competitive corporate system hasbeen sustained because it proposes not incremental improvements in cost orquality for the pre-existing set of goods and services but, rather, revolutionarychanges in the basic organizational and market structures of the economy. Simi-larly, the corporate system does not offer incremental reforms to the frameworkof professional dominance in medicine but has swept it away completely, alongwith fragmented physician practice, arm’s-length indemnity insurance, and cost-unconscious consumer demand. In the final analysis, it is not incrementalimprovement in price and quality that counts, but rather the radical competitionfrom the entirely new product and service, the new technology, the new sourceof supply, and the new type of organization—competition that strikes not at themargins of the profits and the outputs of the existing organizations but at theirfoundations and their very lives. This is the corporate practice of medicine.

Notes

1. D.W. Douglass and J.C. Miller, “Quality Competition, Industry Equilibrium, andEfficiency in the Price-Constrained Airline Market,” American Economic Review,64 (1974): 657-669; E.E. Bailey, D.R. Graham, and D.P. Kaplan, Deregulating theAirlines (Cambridge, MA: The MIT Press, 1985); the classic paper on the cost-increasing effects of competition in the presence of rate regulation is G.J. Stigler,“Price and Non-Price Competition,” Journal of Political Economy, 76 (1968): 149-154; R.H.K. Vietor, Contrived Competition: Regulation and Deregulation in America(Cambridge, MA: Harvard University Press, 1994).

2. H. Averch and L. Johnson, “Behavior of the Firm under Regulatory Constraint,”American Economic Review, 52 (1962): 1052-1069; P.L. Joskow and R. Schmalensee,“Incentive Regulation for Electric Utilities,” Yale Journal on Regulation, 4/1 (1986):1-49; P.L. Joskow, “Regulatory Failure, Regulatory Reform, and Structural Change in the Electric Power Industry,” Brookings Papers: Microeconomics (1989),pp. 125-199.

3. A.F. Friedlander and R.H. Spady, Freight Transport Regulation: Equity, Efficiency, and Competition in the Rail and Trucking Industries (Cambridge, MA: The MIT Press,1981); T.E. Keeler, Railroads, Freight, and Public Policy (Washington, D.C.: TheBrookings Institution, 1983); A.F. Friedlander, E.R. Berndt, and G. McCullough,“Governance Structure, Managerial Characteristics, and Firm Performance in theDeregulated Rail Industry,” Brookings Papers: Microeconomics (1992), pp. 95-183.

4. A.N. Berger, A.K. Sashyap, and J.M. Scalise, “The Transformation of the U.S.Banking Industry: What a Long Strange Trip It’s Been,” Brookings Papers on Eco-nomic Activity, 2 (1995): 55-218.






5. A. DeVany and W.D. Walls, “Natural Gas Industry Transformation, CompetitiveInstitutions, and the Role of Regulation,” Energy Policy, 22/9 (1994): 755-763;K.W. Costello and D.J. Duann, “Turning Up the Heat in the Natural Gas Industry,”Regulation, 1 (1996): 52-59; R.H.K. Vietor, Contrived Competition: Regulation andDeregulation in America (Cambridge, MA: Harvard University Press, 1994).

6. G.J. Stigler, “The Theory of Economic Regulation,” Bell Journal of Economics andManagement Science, 2 (1971): 22-50; S. Pelzman, “Toward a More General Theoryof Regulation,” Journal of Law and Economics, 19 (1976): 211-240; G. Becker, “ATheory of Competition among Pressure Groups for Political Influence,” QuarterlyJournal of Economics, 98 (1983): 371-400; S. Pelzman, “The Economic Theory ofRegulation after a Decade of Deregulation,” Brookings Papers: Microeconomics,(1989), pp. 1-41; A.E. Kahn, The Economics of Regulation: Principles and Institutions(New York, NY: John Wiley, 1971, second edition 1988); P.L. Joskow and R.C.Noll, “Regulation in Theory and Practice: An Overview,” in G. Fromm, ed., Studiesin Public Regulation (Cambridge, MA: MIT Press, 1981); M.W. White, “PowerStruggles: Explaining Deregulatory Reforms in Electricity Markets,” BrookingsPapers: Microeconomics (1996), pp. 201-267.

7. A.E. Kahn, “Deregulation: Looking Backward and Looking Forward,” Yale Journalon Regulation, 7 (1990): 325-354; C. Winston, “Economic Deregulation: Days ofReckoning for Microeconomists,” Journal of Economic Literature, 31 (1993): 1263-1289; J.R. Meyer and W.B. Tye, “Toward Achieving Workable Competition inIndustries Undergoing a Transition to Deregulation: A Contractual EquilibriumApproach,” Yale Journal on Regulation, 5 (1988): 273-297; R.H.K. Vietor, ContrivedCompetition: Regulation and Deregulation in America (Cambridge, MA: Harvard Uni-versity Press, 1994).

8. These quantitative estimates are derived from the literature survey in C. Winston,“U.S. Industry Adjustment to Economic Deregulation,” Journal of Economic Perspec-tives, 12/3 (1998): 89-110.

9. Fare ceilings imposed by Civil Aeronautics Board had stimulated non-price com-petition through more frequent flights, reducing occupancy rates and raisingaverage costs per passenger mile, and it was anticipated that deregulation wouldreduce frequency by stimulating price competition. However, the increase indemand stimulated by the lower prices more than compensated for thefrequency-reducing impact of higher seat occupancy rates.

10. K.J. Arrow, “Uncertainty and the Welfare Economics of Medical Care,” AmericanEconomic Review, 53/5 (1963): 941-973.

11. D.A. Banks, S.E. Foreman, and T.E. Keeler, “Cross-Subsidization in Hospital Care:Some Lessons from the Law and Economics of Regulation,” Health Matrix Journalof Law-Medicine, 9 (1999): 1-35.

12. For an overview of the economics of professional dominance, see J.C. Robinson,The Corporate Practice of Medicine: Competition and Innovation in Health Care (Berkeley,CA: University of California Press, 1999), Chapter 2.

13. R.G. Noll, “Economic Perspectives on the Politics of Regulation,” in R.Schmalensee and R.D. Willig, eds., Handbook of Industrial Organization (Amsterdam:Elsevier Science Publishers, 1989).

14. K. Levit, C. Cowan, B. Braden, et al., “National Health Expenditures in 1997:More Slow Growth,” Health Affairs, 17/6 (1998): 99-110.

15. For an overview of organizational innovation in physician group practice, see J.C.Robinson, op. cit., Chapters 5-8.

16. The BNA Health Plan and Provider Reporter provides a weekly summary of fed-eral and state anti-managed care legislation and regulation. The figure on 10,000bills was derived from analyses by the Health Insurance Association of America






and National Conference of State Legislatures. Bureau of National Affairs, BNAHealth Plan and Provider Reporter, June 28, 2000): pp. 758-759.

17. The cognoscenti will recognize the debt of this paragraph to J.A. Schumpeter,Capitalism, Socialism, and Democracy (New York, NY: Harper and Row, 1942).



Harvard Business School Industry and Competitive Strategy Articles

Finding a Lasting Cure for U.S. Health Care


Finding a Lasting Cure forU.S. Health Care

Perspectives

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H. KENT BOWEN, KIM B. CLARK, SPECIAL SECTION:CHARLES A. HOLLOWAY, REGAINING THE LEAD IN MANUFACTURINGDOROTHY LEONARD-BARTON,STEVEN C. WHEELWRIGHT DEVELOPMENT PROJECTS: THE ENGINE OF RENEWAL 94501

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Reprint Number




anything less than the best treat-ments available.

The misguided assumption under-lying much of the debate abouthealth care is that technology is theenemy. By assuming that technolo-gy drives up costs, reformers neglectthe central importance of innova-tion or, worse yet, attempt to slowits pace.

In fact, the authors argue, innova-tion driven by rigorous competitionis the key to successful reform. Alasting cure for health care in theUnited States should include fourbasic elements: corrected incentivesto spur productive competition, uni-versal insurance to secure economicefficiency, relevant information toensure meaningful choice, and vig-orous innovation to guarantee dy-namic improvement.

Eleven experts examine the cur-rent state of the health care systemin the United States and offer theirviews on the shape that reformshould take. Teisberg, Porter, andBrown then provide a brief response.

P E R S P E C T I V E S

In “Making Competition inHealth Care Work” (July-August1994), Elizabeth Olmsted Teisberg,Michael E. Porter, and Gregory B.Brown consider a question that hasbeen conspicuously absent from thecurrent national debate on healthcare reform: How can the UnitedStates achieve sustained cost reduc-tions over time?

The authors find the answer in thepowerful lessons that business haslearned over the past two decadesabout the imperatives of competi-tion. In industry after industry, theunderlying dynamic is the same:competition compels companies todeliver constantly increasing valueto customers. The fundamental driv-er of this continuous quality im-provement and cost reduction isinnovation. Without incentives tosustain innovation in health care,short-term cost savings will soon beoverwhelmed by the desire to widenaccess, the growing health needs ofan aging population, and the unwill-ingness of Americans to settle for

HARVARD BUSINESS REVIEW September-October 1994 Copyright © 1994 by the President and Fellows of Harvard College. All rights reserved.


Can health care reform in the United States achieve long-term cost reductions and maintain quality of care?




6 HARVARD BUSINESS REVIEW September-October 1994

I. Steven UdvarhelyiVice President, Medical ServicesThe Prudential Insurance Companyof AmericaExecutive Vice President The Prudential Center for HealthCare ResearchPhiladelphia, Pennsylvania

As Elizabeth Teisberg, MichaelPorter, and Gregory Brown argue,the failure of U.S. medicine to pro-duce cost innovation has contribut-ed significantly to the difficulty wehave in controlling health care costs.And cost innovation is critical if wewant to succeed at reducing costsand improving quality in a world offixed resources. However, the au-thors fail to emphasize some impor-tant issues and do not present othersin their full complexity.

The assertion that payers try todeny payment on claims wheneverpossible is just such an oversimplifi-cation. As the authors point out, ThePrudential Insurance Company ofAmerica has demonstrated throughits Institutes of Quality Programthat incentives can be aligned toproduce cost savings and improvequality. And our case is far from anisolated one. Health maintenanceorganizations cover and pay for morecomprehensive preventive care thantraditional fee-for-service plans do.Some HMOs actually pay expectantmothers on Medicaid to come in forcare. HMO managers understandthat an HMO is responsible for thehealth of a defined population,rather than for a series of individualswith individual health problems. Ifwe are to solve the problems of thehealth care system, we must startthinking in these same terms.

Indeed, the use of new health caretechnologies requires just such anapproach. The authors are correct tosay that we should not slow techno-logical innovation in health care, es-pecially innovation that can reducecosts. But the diffusion of technolo-gies into widespread medical prac-tice prior to an adequate assessmentof their risks, benefits, and appropri-ate relative roles should be slowed.The push for rapid dissemination ofnew technologies is most prevalent

where current therapies are limitedin their effectiveness. While it isunderstandable that individuals maywish to try new, unproven technolo-gies in such situations, as a societywe must collect data that demon-strate the effectiveness of new tech-nologies rather than submit a largenumber of individuals to unknownrisks for unknown benefits. Gather-ing information on whether or not a new technology produces betterhealth outcomes – or equal health outcomes at a lower cost – is almostimpossible if the technology has be-come practice before data are col-lected and analyzed.

The argument that we will im-prove innovation by providing con-sumers, specifically individual pa-tients and other purchasers, withbetter information on health out-comes is true but again oversimpli-

fied. In the financial services mar-kets, we have seen the developmentof bond ratings as aggregate mea-sures of performance, partly becauseindividual investors cannot makeuse of detailed, individual financialreports on bond stability and project-ed yields. Why should medicine bedifferent? Many individual con-sumers will have difficulty inter-preting outcome data on complexmedical treatments and proceduresand weighing the risks and benefitsassociated with different approachesto treatment. We should anticipatethe equivalent of an aggregate “bondrating” in medicine that allows thelay public to evaluate competingphysicians, hospitals, and healthplans. In addition, we should expectindividuals to get better advice fromphysicians who are better informedthan most physicians are today.

To that end, extensive researchthat develops better outcome mea-sures must be undertaken quickly;however, that research should notsimply focus on measures that areimportant to individual patients orto group purchasers, such as employ-ers. The information needs to beuseful to physicians, and the out-come data need to be coupled with a better understanding of whichclinical processes produce the bestoutcomes. It is critical that the foun-dation of clinical decision making be improved. The health care sys-tem of the future will place lessemphasis on the decision-makingabilities of individual physicians andmore on the decision-making abili-ties of a team of individuals workingtogether–a team that should includethe patient. This new system ofhealth care delivery will require newways of supporting and making deci-sions in order to improve medicaloutcomes. Information and outcomedata should be available to all deci-sion makers so that better informed,and better coordinated, recommen-dations can be made about treat-ment options. Such data should per-mit physicians to improve their ownperformance, permit each decisionmaker to understand the relation-ship of outcomes to the performanceof other team members, and pro-vide patients with information that

“On the road toinnovation, letus not forget to

develop thetools that allow

physicians,payers, andpatients to

make betterdecisions.”

I. Steven Udvarhelyi




HARVARD BUSINESS REVIEW September-October 1994 7

points out the pros and cons of dif-ferent treatment options. On theroad to innovation, let us not forgetto develop the tools that allowphysicians, payers, and patients tomake better decisions.

Arnold S. RelmanProfessor of Medicine and ofSocial MedicineHarvard Medical SchoolEditor-in-Chief EmeritusThe New England Journal of MedicineBoston, Massachusetts

The authors are largely correct intheir description of the inefficien-cies and skewed incentives of thepresent health care system in theUnited States, but their suggestedremedy can’t work. They prescribe astrong dose of “productive competi-tion,” as if health care were simply a business in which competition hasnot been allowed to work its usualmagic. A lifetime of involvement inthe practice, teaching, and study ofmedical care has convinced me thatthis view, so commonly held bybusinesspeople and economists, ismisguided. Health care is not a prod-uct or a simple service that can bestandardized, packaged, marketed,or adequately judged by consumersaccording to quality and price. Theauthors correctly recognize that “in-formed purchasing decisions” have,to date, had little influence on sup-ply and demand in health care. Butthey are wrong if they believe thathealth care can be made to behavelike other parts of the U.S. economythrough the stimulation of competi-tion and the use of “meaningful out-come measures.”

Medical care is a highly personaland individualized service, the valueand success of which can be fully as-sessed only with respect to a particu-lar individual in particular circum-stances. Yes, it is true that narrowlydefined “outcomes” of certain pro-cedures can be measured and report-ed in statistical, probabilistic terms,but such data cannot capture the al-most infinite variety of personal cir-cumstances that determine the val-ue of these procedures to a particularpatient. There is an enormous and

rapidly growing literature on theprobable effects of given proceduresin particular medical conditions, butjudgments on the quality of care in a given patient rarely can be based onsuch information.

Business managers don’t under-stand why they shouldn’t be able toget reliable information about quali-ty of care, which they can weighagainst the prices charged. The factis that the measurement of quality isin a primitive state and will probablyremain so for the foreseeable future.Here is the best definition of high-quality medical care that I can comeup with: It is the care given to a par-ticular patient under particular cir-cumstances by a compassionate andcompetent physician who has accessto consultants and the best currentinformation, who is not influencedby economic incentives to do more

or less than is medically appropriate,and who is committed to serve thepatient’s best interests guided by the latter’s wishes and medical needs.This definition emphasizes the phy-sician’s key role in allocating medi-cal resources and preserving stan-dards of quality.

Now, if what I have said about themeasurement of quality and the roleof physicians is correct, how likelyis it that market competition cansolve the present problems of ourhealth care system? What we needinstead is a reorganization of medi-cal practice to emphasize communi-ty-based not-for-profit group prac-tices, and the development of newincentives for physicians and otherhealth care providers to act as pru-dent counselors for their patients.Unlike ordinary markets, health careneeds some overall limitation of ex-penditures. A national health insur-ance system could provide a rationaland equitable basis for establishingspending limits, subject to publicapproval. However, the use of avail-able resources within agreed-uponnational limits should be the respon-sibility of health care professionalsworking with their patients.

The authors envision a competi-tive, market-driven health care sys-tem in which for-profit investor-owned companies take responsibilityfor providing care and expect finan-cial rewards in exchange for riskingcapital. What happens to the doctor-patient relationship in that kind ofmarket? If sick patients are not like-ly ever to function as independentprice-and-quality-sensitive consum-ers do in ordinary markets, how dowe ensure that the economic incen-tives of investors do not compro-mise the quality and availability ofcare? Caveat emptor is the rule inmost markets. Who would want tobe cared for in a health system builton that principle?

Gordon M. BinderChairman and CEOAmgenThousand Oaks, California

The biotechnology industry offersliving proof of Teisberg, Porter, and

“Health care isnot a product ora simple service

that can bestandardized,

packaged,marketed, oradequatelyjudged by

consumersaccording toquality and

price.”Arnold S. Relman




Brown’s forceful argument: Decadesof basic research into the geneticcode are now paying off in effectivetreatments and potential cures forillnesses that have long eluded med-ical researchers. New drug thera-pies for heart disease, diabetes,leukemia, cancer, and kidney dis-ease are available to patients, andbiotech researchers are determinedto eradicate AIDS, Parkinson’s dis-ease, and even cancer.

Biotechnology drugs offer patientsbetter and more cost-effective thera-pies, and they often help avoidsurgery and hospitalization. For ex-ample, a biotechnology drug we developed at Amgen, Neupogen, isgiven to patients undergoing chemo-therapy to decrease their risk ofinfection. In clinical trials at DukeUniversity Medical Center, Neupogenhas helped reduce the cost of bonemarrow transplantation for womenwith breast cancer from $140,000two years ago to $65,000 today.Many women who had to receivetreatment as hospital inpatients can now receive treatment virtuallyon an outpatient basis. Yes, thismedical care is still expensive, butlives are saved and extended, andquality of life is improved.

This kind of progress can continueonly in an atmosphere of free andcompetitive markets. Innovationand investment are two sides of thesame coin. Before Amgen sold itsfirst product, more than $400 mil-lion had to be raised to fund re-search. The scientific discoveriesthat will create today’s medical mir-acles can evolve only in an environ-ment that rewards the enormousrisk that entrepreneurial companiesassume in conducting research.

The United States is on the brinkof stunting this progress. Under thethreat of price controls, investor in-terest in the health care industry isdrying up. The biotech industryraised only $1.6 billion in the publicmarket in 1993, down from $3.7 bil-lion in 1991, according to Mont-gomery Securities, an investmentbank based in San Francisco. Underthreats of the price controls andadded regulation that the Clintonadministration has proposed, thenumber of new biotech companies

dropped from 120 in 1987 to 40 in1993. Sixty percent of the companiesthat planned to raise capital in 1993either missed funding targets or can-celed stock offerings. An astonishing100% said that investor concernabout price controls has been harm-ful to their ability to raise funds.Clearly, the threat of price controlsis already having a negative impacton medical research.

Some members of Congress haveworried that if a cure for AIDS is de-veloped, it may be too expensive.But the most cost-effective healthcare is a cure – or, better yet, a vac-cine. For example, in 1952, morechildren died of polio than of anyother infectious disease, and poliowas much feared as the great cripplerof children. After a concerted cam-paign to fund many millions of dol-lars of research, the Salk vaccine was

developed, virtually eliminating po-lio as a threat. Who can estimate thevalue of the lives saved and the chil-dren who were not crippled becausethey received the vaccine in time?

While we have made dramaticstrides in medical research, the wayhealth care is financed and deliveredin the United States today needs tobe changed. Too many people gowithout the medical treatment theyneed, and too many others facecatastrophic medical expenses whenthey have a major illness. But short-sighted efforts to control prices areself-defeating and undermine scien-tific progress.

It is imperative that public-policy-makers respect the vibrant con-nection between innovation and in-vestment. The genius of medicalresearch goes hand in hand with thegenius of the competitive market.The cure for the ailments of the U.S.health care system is not increasedgovernment regulation, price con-trols, and mandates but a healthy, vi-brant market that offers ever moreeffective and ever more cost-effec-tive treatments and cures.

Rina K. SpencePresidentRKS Health Ventures CorporationCambridge, MassachusettsFormer CEOEmerson HospitalConcord, Massachusetts

The authors have accurately iden-tified many of the barriers to suc-cessful competition and therefore tosustained cost savings. I would addyet another barrier: the complexityof medical culture and politics.

Innovation and competition mayappear to be stifled by regulators andlegislation, but in fact the conserva-tive nature of much of the healthcare industry itself – hospitals andinsurers included – contributes sig-nificantly to the problem. The medi-cal community is fundamentallyrisk-averse. While clinically sound,this stance poses a real problemwhen it comes to implementingchange in the structure of the healthcare system. And the problem is on-ly exacerbated by political forcesthat generally promote the self-


“The scientificdiscoveries that

will createtoday’s medical

miracles canevolve only in

an environmentthat rewards

the enormousrisk that

entrepreneurialcompaniesassume in

conductingresearch.”

Gordon M. Binder8




preservation of existing medicalpractices and community institu-tions. Risk-averse behavior mani-fests itself in all areas of health caredelivery, and much of the paymentstructure that exists today was putinto place precisely to limit the levelof risk undertaken by practitioners,hospitals, and insurers alike.

Today’s innovative and cost-effec-tive forms of service delivery willnecessarily involve taking risks, in-cluding acceptance of nonphysiciancaregivers, nontraditional modes ofcare, and less costly sites for servicedelivery. Indeed, the new paymentscheme, capitation, is fundamental-ly risk based. Physicians, hospitals,and other providers will receive afixed dollar amount per patientbased on an educated guess concern-ing the total cost of providing carefor their populations. Because of thefinancial risk involved in serving apopulation under capitation, theseentities will have to become moreefficient and find new ways of deliv-ering high-quality care without ex-ceeding their operating budgets.

Given these new dynamics, an in-dustry that has been risk-averse willhave to change its culture to achievesuccess. I believe that there is roomfor successful niche approaches tohealth care. After ten years as a hos-pital CEO, I changed paths in orderto see if one could create innovativeservice delivery by stepping outsidethe existing culture and politics of a traditional institutional setting.Could one build a more cost-effec-tive staffing structure, purchasingsystems, and equipment based onlyon cost and quality, and offer ser-vices based on consumer demand?RKS Health Ventures, my answer tothat question, is a private outpatientnetwork of consumer-oriented wom-en’s health facilities. These serviceswill be delivered cost-effectivelywith an ability to incorporate risk-based reimbursement.

The private, for-profit sector is al-so seeking new business opportuni-ties through different managementof old structures. Large hospital cor-porations are purchasing hospitals,and those corporations may be bet-ter able to consolidate services andregionalize care because they are not

party to the old politics and culture.They are also rapidly developinglower-cost alternatives for healthcare delivery, such as subacute-careand rehabilitation centers.

The health care industry canachieve sustained cost-effective-ness. To that end, the system mustbe reengineered, breaking down thecurrent paradigm of who, how, andwhere health care is delivered.

Edward M. KennedySenator, MassachusettsChairman, Committee on Labor and Human ResourcesWashington, D.C.

“Making Competition in HealthCare Work” is a powerful prescrip-tion for reform. The authors’ analy-sis is fundamentally compatiblewith the Health Security Act pro-

posed by President Clinton and re-cently approved in modified form bythe Committee on Labor and Hu-man Resources. Everyone’s first pri-ority in Congress is to unleash theforces of competition in order toachieve long-term cost reductions,continuous quality improvements,and innovation. But the real chal-lenge is how to do it.

The Health Security Act addressesthe problems and will foster the in-novation that Teisberg, Porter, andBrown identify as the key to long-term cost control. A solution to thecost problem, as the authors rightlyemphasize, requires universal cover-age. The Health Security Act en-sures that every citizen will have in-centives to choose the highest-valuehealth plan from among a number ofdifferent plans. Employees choosingmore expensive plans will pay more;those choosing less expensive planswill pay less. And they will receive a cash rebate if they choose a planthat costs less than the employer’scontribution. Coverage will be com-prehensive and standardized so thatpeople can compare plans on priceand quality without the subtle dis-tortions introduced when benefitsvary among plans.

The program also improves thenegotiating power of citizens by re-ducing fragmentation. Employerswith fewer than 500 employees, aswell as the self-employed and theunemployed, will purchase coveragethrough community-rated pools,and they will be able to exert consid-erable market power to curb costs.Employers with more than 1,000employees will purchase coverageoutside the pools. Companies with500 to 1,000 employees will have achoice: they can purchase coveragedirectly or participate in pools. Theplan gives citizens still anotherchoice by making the Federal Em-ployees Health Benefits Programavailable to nonfederal employees.

The Health Security Act is alsoconsistent with a number of the oth-er recommendations made by Teis-berg, Porter, and Brown. It recog-nizes that good information onquality of care is an essential part ofmaking health care work. A con-sumer report card on each health


“The medicalcommunity isfundamentally

risk-averse.While clinically

sound, thisstance poses areal problem

when it comes to

implementingchange in the

structure of thehealth caresystem.”

Rina K. Spence9





plan must be developed and madeavailable, using the most up-to-dateand comprehensive information onmedical outcomes. A major addi-tional investment must be made inoutcomes research and the develop-ment of practice guidelines.

The Health Security Act simpli-fies the content of health insurancepolicies, outlawing balance billingand providing for patient cost shar-ing in the standardized policies. Bysubstantially expanding funds formedical research and academichealth centers, the act sends a mes-sage that cost savings should beachieved by developing and dissemi-nating new cures for diseases, ratherthan by restricting the availability ofnew products. Indeed, our proposalcarefully avoids the micromanage-ment and regulation of the price ofspecific products and services, newor old, which the authors rightlycaution could stifle innovation. In-stead, each health plan will havestrong incentives to balance the val-ue of a product or service against itscost. In addition, each plan will al-low subscribers to decide whether ornot that provider has struck theright balance by deciding where totake their business.

The main area in which our pro-gram differs from the authors’ rec-ommendations is in its fallbackpremium limits in areas where com-petition alone is not fully effectiveor does not work fast enough. In myview, these premium limits are notincompatible with competition. In-stead, they are a safety net to en-sure that costs do not continue outof control. Excessive inflation is sodeeply embedded in today’s systemthat the availability of such limitsmay be the “stick in the closet” thatis essential to let real competitiontake hold. The experts we heardfrom in our committee hearings gen-erally felt that managed competitionalone might not be sufficient to re-strain rising prices in the short run.The goal is to find the best way tomanage competition. Just as anti-trust laws are the wise restraintsthat make competition free in othersectors of the economy, so the rightkind of managed competition canwork well in health care.

Jerome H. GrossmanChairman and CEONew England Medical CenterBoston, Massachusetts

We health care providers mustchange the elements of practice thatare within our control if we are to re-alize the true benefits of new mar-ketplace incentives.

Consider outcome measures. Themarketplace, the delivery system,and patients are best served by at-tending to four categories of out-comes: clinical health (traditionalbiomedical and physiological healthstatus); functional health (quality oflife and general well-being); satisfac-tion (the consumer’s attitudes andresponses to the experience of seek-ing and receiving care); and cost (thecosts of care to achieve the desired

level of health outcomes). Fortu-nately, we are making rapid stridesin our ability to measure all four cat-egories. Developments in the field ofpsychometrics are making it possi-ble to utilize patient- and consumer-based survey instruments of great re-liability and accuracy.

Essential to adopting outcomemeasures in health care settings isinstalling appropriate state-of-the-art information systems. The healthcare system has lagged behind otherindustries in its use of computersand information systems. Only re-cently have we begun looking in amethodical way at the bigger pictureof how structure, process, and out-comes are intertwined and how op-erations can be adjusted to improveresults. Today we are creating a newgeneration of decision-support sys-tems to help clinicians and man-agers make the most efficient use ofresources while delivering the mosteffective health care services. Thedevelopment of health-care-infor-mation systems may prove to be themost significant innovation of all.

The health care system is alreadychanging dramatically because themarketplace, led by powerful payers,is transforming itself in ways thatthe authors would endorse. Thisevolution will continue, regardlessof the actions of Congress. Many ofus who are directly responsible forproviding health care see an oppor-tunity to improve the health of thepopulation and at the same time en-hance our own professional satisfac-tion. The fact is that we physicianshave grown increasingly frustratedwith a system that imposes micro-management by payers, dictatingwhat we can and cannot do for ourpatients. The alternative: pay us forwhat we accomplish, not what wedo. Provide us with a predeterminedand appropriate capitation rate tocare for an enrolled population,make us accountable for deliveringnecessary care within the limits ofthis budget, and help us measure andmonitor the outcomes to ensure thatwe don’t sacrifice quality for profits.If we succeed in improving out-comes at reduced costs, we stand togain by increasing our margins andsecuring market share.

“Just asantitrust lawsare the wise

restraints thatmake

competitionfree in othersectors of the

economy, so theright kind of

managedcompetition can

work well inhealth care.”

Edward M. Kennedy





Physicians and providers are re-sponding to this evolving shift to ahealth care system based on “cov-ered lives” rather than “covered ser-vices” by building organized and in-tegrated delivery systems, reviewingand amending practice patterns, andcontrolling expenditures. Undercapitation, providers will makesmart purchasing decisions, so thatinnovations that make sense will berewarded. This, in turn, sets the con-text for pharmaceutical and medicaldevice companies to produce cost-effective, labor-saving advances thattruly improve the outcomes of care.In this way, we will structure an in-dustry and a marketplace to achieveour goals of high-quality and afford-able health care.

Henri A. TermeerChairman, President, and CEOLisa J. RainesVice President for Government RelationsGenzyme CorporationCambridge, Massachusetts

The pharmaceutical marketplaceprovides a microcosm for Teisberg,Porter, and Brown’s critique of theU.S. health care system’s self-con-tradictory incentive system. Pre-scription drugs are usually the mostcost-effective way of treating a dis-ease, but neither Medicare nor halfof all private insurance policies cov-er outpatient drugs. As a result, pa-tients are sometimes tempted – orforced by economic circumstance –to forgo filling a $50-per-month pre-scription that significantly reducesthe probability of a more debilitatingand expensive heart attack or stroke.And Medicare’s policy of coveringinpatient–but not outpatient–drugshas led many oncologists to admitcancer patients to the hospital at asubstantial cost to Medicare for thepurpose of qualifying the patient’schemotherapy for reimbursement.

The Clinton administration’shealth-care-reform plan recognizesthe foolishness of a system that willpay for a $20,000 surgical procedurebut will not pay for a $2,000 drugthat eliminates the need for surgery.The plan proposes to remedy this sit-uation by requiring all public and

private payers to cover outpatientprescription drugs. Yet the details ofthis proposal, particularly the Medi-care portion, could be improved ifmade more consistent with the au-thors’ suggestions. Under the Clin-ton plan, if two brand-name drugsare therapeutically equivalent butone drug costs twice as much as theother, Medicare would pay forwhichever drug a physician pre-scribes. The plan has no meaningfulmechanism for encouraging thephysician to use the less expensivebut equally effective product. In con-trast, HMOs and pharmacy-benefitmanagers direct physicians to pre-scribe the least expensive therapeu-tically equivalent product. Further-more, the administration’s proposalwould pay pharmacists a $5 dispens-ing fee for each Medicare prescrip-tion – almost twice the average fee

negotiated by managed care organi-zations – and would prohibit some of the types of discounting and prod-uct bundling arrangements that al-low manufacturers to either cut thecost or increase the value of theirproducts in ways dictated by an in-creasingly competitive marketplace.

Perhaps most ominously, the ad-ministration’s Medicare proposalwould authorize the secretary ofhealth and human services to “nego-tiate” a rebate for new drugs if she“believes the manufacturer’s retailprice may be excessive.” It seems ob-vious that if Medicare can demand arebate of unlimited size, it has theabsolute right to set the product’sprice with respect to the Medicaremarket. For drugs that are usedprimarily or exclusively by elderlypatients – such as those for Alz-heimer’s, arthritis, and many can-cers – Medicare would control theprice for the entire U.S. market.

Diseases of the elderly account forabout half of all health care costs,and that amount will increase as ournation ages demographically. Ouronly hope for a sustained reductionof those costs is to create new meth-ods of treatment that reduce theneed for hospitalization, surgery,and nursing home care. The struc-ture of the administration’s Medi-care proposal undermines these in-centives by imposing price controlsthat would make drug developmentunattractive to investors who have a myriad of non-price-controlled in-vestments from which to choose.

A better approach to a Medicaredrug benefit would be to allow phar-macy-benefit managers and HMOsto administer the program. Such pri-vate-sector organizations have dem-onstrated success in containing pre-scription drug costs through the use of generic substitution, thera-peutic substitution, and price nego-tiations with drug manufacturers,while avoiding the regulations, pricecontrols, paperwork, and inefficien-cy that would likely accompany agovernment-run program. As the au-thors note, the federal governmentcan make an intellectual contribu-tion to such a program through ex-panded outcomes research and tech-nology-assessment studies that

“The fact is that we

physicians havegrown

increasinglyfrustrated witha system that

imposesmicromanage-

ment by payers,dictating what

we can andcannot do forour patients.”Jerome H. Grossman




provide payers, providers, and pa-tients with relevant informationabout the relative merits of varioustherapeutic approaches.

Beyond assessing the merits of in-dividual products and services, how-ever, we need to achieve a socialconsensus that recognizes the valueof innovation. The debate aboutwhether innovation drives costs upor down, whether it improves medi-cal outcomes or not, will continue inthe absence of a meaningful evalua-tion of these issues.

Elizabeth MarincolaExecutive DirectorThe American Society for Cell BiologyBethesda, Maryland

It is curious that innovation, andin particular biomedical research,has not figured more prominently inthe national health care debate. Thisomission may be a function of thecontrast between the short-termpressures of politics and the long-term ones of science. As the authorspoint out, longer-term changes inhealth care are needed, requiringnew insights at the most basic level.

In the current climate of perverseeconomic incentives, those who aremost vocal in the health care de-bate – elected officials and advoca-cy groups representing people withdiseases – can be the unintentionalenemies of economic efficiency. Ac-cording to these officials and ad-vocates’ biased view of innovation,federal appropriations for biomedi-cal research are defined as being for the social good. They are notmeasured in terms of economic re-turns. Biomedical research shouldbe considered primarily an invest-ment in the national economic well-being with additional humanitar-ian benefits. Like the Japanese, weshould consider federal funding ofbiomedical research to be an invest-ment in R&D for the health care in-dustry, just as electronics research isthe R&D for the computer industry.

Resistance to investing in re-search also comes from the mislead-ing but popular public claim that al-though technological innovationincreases the quality of health care,

it also always increases costs. In fact,cost increases are often not causedby the technology per se but arerather artifacts of the suboptimaluse of diagnostic equipment, such asthe nonconsolidation of expensivehigh-tech capital investments likemagnetic resonance imaging. As theauthors correctly claim, there mustbe some regionalization of special-ized services so that patients canbenefit from state-of-the-art tech-nology free of incentives that en-courage its overuse because toomany owners need to recoup theirinvestment in expensive machines.

The authors also make a good casethat the manipulation of incentivesfor payers, consumers, and providersshould result in the actual reductionof health care costs, not just in theirredistribution. Economic incentivesand regulatory reforms can and

should be improved – but they canonly produce savings on the margin.In an economic climate that seeks tooptimize value, we can expect thatfundamental research will lead tobetter-quality treatments at lesscost. The only mechanism for signif-icant change in the cost of treatingdisease is basic biomedical research,which presently consumes a verysmall fraction (less than 2%) of thehealth care budget.

Unfortunately, analysis of the eco-nomic impact of such research isincomplete. Nevertheless, ample evi-dence exists demonstrating the dra-matic returns of successful biomedi-cal research. Hepatitis B vaccine isestimated to save as much as $94.7million per year by preventing acuteand chronic disease. The develop-ment of genetic screening tech-niques for neonatal hypothyroid-ism allows 97% of infants withcongenital hypothyroidism to beidentified early enough to avoid themental retardation that otherwiseresults from this condition. Any sin-gle breakthrough of basic biomedicalresearch could alone produce moresavings in health care costs in oneyear than the entire federal budgetfor the National Institutes of Health,which funds most biomedical re-search in the United States.

The emphasis on innovation driv-en by biomedical research, whichhas been shamefully ignored so far,must be a central element in the re-formulated debate on health care re-form. Although it is complicated tomeasure accurately the cost savingsproduced by biomedical research,federal policy that uncouples suchresearch from the economics ofhealth care delivery undervalueswhat will ultimately prove to be ourmost direct avenue to both increas-ing the quality of health care andlowering its costs.

Thomas O. PyleManaged Care Manager and Policy Analyst Metropolitan Life Insurance CompanyWestport, Connecticut

The authors have provided uswith a compelling description of the


“Biomedicalresearch shouldbe consideredprimarily an

investment inthe national

economic well-being withadditional

humanitarianbenefits.”

Elizabeth Marincola

12




problems in health care economicsand practices. Solutions, however,are harder to find. The view that in-centives are needed and that compe-tition is good is repeatedly asserted.But these icons of market-drivensystems, of which I am a firm advo-cate, are not easy to implement inhealth care. Moreover, the authorsnever tell us how they would do it.

The problems are myriad. For in-stance, since health care coverage isa futures contract, it is inherentlyspeculative. The desire to partici-pate in advantageous aggregationsby either buyer or seller is called ad-verse selection and skimming, re-spectively. It is the Achilles’ heel ofcompetition in health care. The in-ability to identify inherent risk inpopulation groups only compoundsthe problem and prevents large em-ployers in the United States fromcomparing performance betweenthe various HMOs and indemnityplans it offers; it stymies any simplecomparison of outcomes.

The problem of gaming extendsfrom health care insurance into thedelivery system. Gaming, of course,is characteristic of all businesses,but it’s rarely defended in other in-dustries with the degree of sancti-mony and professional weight thatis thrown around in health care. Allincentive systems have side effectsthat must be monitored or offset.Even a pure salary system, describedin the article as “volume neutral,”is, in fact, not volume neutral. Whileit will not stimulate the volume ofprocedures, a pure salary system willtend to reduce access and decreaseproductivity.

The proposals for managed com-petition, largely the work of AlainEnthoeven and Paul Ellwood, and also known as the Jackson Hole pro-posals, have a good deal more meritthan the article suggests. (I admit tobias, since I was chairman of theJackson Hole Group from 1991 to1993.) The main purpose of the pro-posals is to create a workable mar-ket. The Jackson Hole proposals callfor the development of HMO-likeorganizations called accountablehealth plans (AHPs). These AHPswould assume full responsibility forcost and quality in any individual’s

care and would publish performancedata. They would compete on thebasis of the full array of service at-tributes, with consumers periodical-ly selecting a new plan if they weredissatisfied or felt a new plan offereda more satisfactory package. Forsmaller employers, a health storewould help the choice process.These health stores would be non-regulatory entities that would facili-tate the distribution of AHPs to pro-mote availability and competitionand handle the accounting (admit-tedly primitive) for risk adjustment.

Each AHP would compete in amedical market, roughly defined asan area of variable size in which a high percentage of the medicaltransactions occur for both the pop-ulation and the set of institutions located within. Plans might be sin-gle-market, like the Harvard Com-

munity Health Plan in GreaterBoston, or multimarket, like KaiserPermanente, serving markets na-tionwide. Each market, however,would essentially be a stand-alonebusiness. These organizations wouldhave a strong incentive to improveperformance both individually andby developing consortia with othersto sponsor research. While the pos-sibility exists that a high-qualityprovider might be excluded, marketincentives would encourage includ-ing the providers who offer the best value. And the AHP would havegreater capabilities to distinguishhigh-quality providers than wouldany individual. The idea that all pro-viders need to be included meansincluding many bad providers andundermining cost-effectiveness.

While one can envision a timewhen medical standards and perfor-mance data would permit competi-tion on individual types of services,the present state of the art does notallow meaningful competition insuch a model. And who would thedecision maker be: the employer,the patient, or the insurer? Howwould we link payment responsibili-ty with authority to choose? We buymost of our products, such as auto-mobiles, assembled with the namedmanufacturer taking competitive re-sponsibility for component qualityand cost. In the arcane world ofhealth care and health care financ-ing, to do otherwise would perpetu-ate the gaming so well described inthe first part of the article.

Ben L. HolmesVice PresidentGeneral Manager of Medical Products GroupHewlett-Packard CompanyAndover, Massachusetts

It is true that innovation, best at-tained through healthy competition,is critical to the success of compre-hensive and sustained health care re-form. The interests of the three pri-mary links in the health care chain–patients, providers, and payers – arestill largely conflicting, resulting ininefficient, costly, and sometimesineffectual care. However, we are be-ginning to see their interests meld as


“While one canenvision a timewhen medicalstandards andperformancedata would

permitcompetition onindividual typesof services, thepresent state ofthe art does not

allowmeaningful

competition.”Thomas O. Pyle 13





Elizabeth Teisberg, Michael Porter, and Gregory Brown Respond:

a result of health-care-industrychanges already under way.

Regardless of when a health carebill is passed on Capitol Hill, marketdynamics have already begun to ini-tiate changes to the system, asshown by health-care-system con-solidations and the movement tomanaged care. Legislators and othergovernment agencies should resistinstituting unnecessary, and poten-tially damaging, policies that couldresult in additional layers of bureau-cracy, diluting competition and in-terfering with innovation.

The shifts occurring in our healthcare system should not be ignored orunderestimated. Well before health

care reform became an importanttopic in Washington, there weresigns that the health care industryrecognized the need to restructureitself. One of the most dramat-ic changes – the movement from afee-for-service to a managed caresystem – is causing ripple effectsthroughout the entire industry. Thegoal of the fee-for-service systemwas to manage sick people – whichmeant competing for patients, per-forming tests of perhaps unknowneffectiveness, or having uncertainand unfair guidelines for compensa-tion. In contrast, the goal of man-aged care is to keep patients healthywithin a certain budget. This goal

cannot be achieved without all par-ties assuming more responsibilityfor health care than they have doneunder the old system.

Indeed, we risk achieving thegoals of reform if we focus more oncost – particularly if we implementonly short-term tactical measures.Cost containment cannot be sepa-rated from quality of care and out-comes. Indeed, the three are inextri-cably linked and should be con-sidered collectively.

The need to lower costs is alreadywell documented. With health carerunning at 14% of the GNP evenwhile 38 million Americans areuninsured, we’re spending too much


It is heartening that the respon-dents accept our diagnosis of theproblems with incentives in to-day’s health care system in theUnited States, problems thathave driven up health care costssubstantially. Even more encour-aging is their general endorse-ment of our argument that in-novation, driven by rigorouscompetition, is essential to suc-cessful reform–particularly giventhat the principle of innovationhas been conspicuously absentfrom the national debate onhealth care reform. Rina Spenceunderscores the importance of in-centives for innovation in her cri-tique of the medical culture andthe politics that have discouragednew forms of and facilities forhealth care delivery. Henri Ter-meer, Lisa Raines, Elizabeth Mar-incola, and Gordon Binder eachprovide powerful examples of in-novative therapies that not onlyyield dramatic cost reductionsbut also improve the quality oflife for patients. These commen-tators share our view of the inno-vation-stifling effects of pricecontrols and the need to supportboth basic and applied research.

Of all the respondents, onlyArnold Relman argues that

health care is a special case andcannot rely on competition. Rel-man asserts, “Caveat emptor isthe rule in most markets. Whowould want to be cared for in ahealth system built on that prin-ciple?” Actually, the current sys-tem in the United States is builton that principle. Our argumentis that all “buyers” in the healthcare system – patients, doctors,payers, and employers–will makebetter choices with a combina-tion of more appropriate incen-tives and improved information.

The main debate raised by therespondents centers on just howto restructure incentives andimprove information. Two is-sues concerning how incentivesshould be changed emerge. First,Ben Holmes and Relman raise theissue of spending caps. Holmesholds that industry-initiated re-forms should be sufficient. Rel-man, in contrast, asserts thatoverall spending caps are neces-sary. In our view, health care re-form should be implemented andgiven a chance to work before in-stituting measures like overallspending caps. Such measures areapt to introduce new distortionsin incentives, like biases againstnew treatments and procedures.

Second, Relman and ThomasPyle raise the issue of physicians’incentives. Relman agrees withus that salaries create incentivesthat are preferable to either tradi-tional fee-for-service reimburse-ment, which provides incentivesto overtreat, or the new capita-tion system, which provides in-centives to undertreat. On theother hand, Pyle argues thatsalaries reduce access and de-crease productivity, presumablybecause salaried doctors willwork less or not perform all nec-essary procedures. Pyle’s argu-ment seems to assume thatsalaries must be low and fixed. Ofcourse, underpaying doctorsmakes no sense. Incentives forsalaried physicians will stem notonly from their commitment topatients but also from the possi-bility of bonuses, raises, and ad-vancement. A doctor’s salaryshould reflect the demand for hisor her services, which in turn willreflect both the quality of careand the quality of outcomes thatpatients experience.

There is little disagreementabout the need for improved in-formation. Holmes, for example,underscores the dangers of reformefforts that try to reduce costs




“Bold reform that includes universal coverage is needed.”


and seeing too few results. Yet iso-lating expenditures also ignores howbetter methods of care, from preven-tion to treatment, would not onlycontrol costs but also contribute tobetter health. Without understand-ing what treatments work and howto achieve expected and desiredmedical outcomes, it is virtually im-possible to deliver efficient care. Wecannot, and should not, tackle thesystem of cost without considering a total solution involving quality ofcare and better outcomes.

A key tenet of managed care re-quires all parties to make informeddecisions based on knowledge of ba-sic treatments, costs, and expected

outcomes. Unfortunately, whilehealth care is one of the most infor-mation-rich industries, we are sorelyunprepared to aggregate patient dataand assess the most successful treat-ment methods. Technology can andshould play a stronger role in thecollection and utilization of clinicaland administrative data. Technologymanufacturers and providers are be-ing charged with developing and uti-lizing technologies that providemore information about patients,leading to better outcomes. Hewlett-Packard, for one, is committed tobringing to market products thatachieve those goals. Health careproviders are learning that in order

to survive, they need to operatemore as businesses, providing theircustomers with the best medical ser-vice, competitively priced withmaximum efficiency.

By the time legislation is ap-proved, industry-initiated reformmeasures will have cured much ofwhat ails health care, resulting inmore reasonable costs while improv-ing quality and enhancing outcomes.But this success relies heavily on developing concomitant interestsamong those with the most to loseor gain from a health care solution –those who receive it, those who pro-vide it, and those who pay for it.Reprint 94512


without paying adequate atten-tion to the effect of quality. Thequestions center on how betterinformation will be used and bywhom. Steven Udvarhelyi agreesthat better information and im-proved outcome measures shouldbe developed rapidly but arguesthat only physicians should haveaccess to specific information;the lay public can understand only aggregate ratings of provid-ers. Relman goes a step further,claiming that even physicians areoften unable to base judgmentson outcome data.

Improved, accessible data onmedical outcomes are first andforemost needed for physicians.Those data–in addition to knowl-edge about the individual patientand professional expertise – willallow doctors to make better pro-fessional judgments. In addition,corrected physician incentiveswill guard against the overuseand underuse of treatments. Doc-tors’ judgments should not be re-placed by practice guidelines de-veloped by insurance managers orgovernment bureaucrats. More-over, the benefits of medical out-come data will be amplified ifanyone who wants those data hasaccess to them.

Senator Edward Kennedy, acentral player in shaping healthcare reform, comments that “ev-eryone’s first priority in Congressis to unleash the forces of compe-tition.” We agree with the Sena-tor that bold reform that includesuniversal coverage is needed. (In-deed, in view of the current de-bate, it is notable and encourag-ing that none of the respondentsquestion our argument that uni-versal coverage is necessary forreasons of economic efficiency aswell as equity.) And we supportthe Senator’s efforts, not men-tioned in his response, to demon-strate more convincingly the val-ue of research and innovation.But three aspects of the HealthSecurity Act remain troubling.

First, as Kennedy points out,“fallback premium limits” are aform of price control. Price con-trols will distort incentives andre-create health care inefficiency.

Second, the employer mandateis expedient but inefficient andunnecessary. Providing healthcoverage at the employer levelcreates an unnecessary level ofbureaucracy. A better long-termsolution is to require everyone tohave health insurance, mandate aonetime salary adjustment to

cover the cost of forgone employ-er benefits, provide subsidies tothose who need them, and re-quire age-adjusted community rat-ings by insurers. Coverage mustremain intact when someonemoves or changes jobs, and insur-ers and buying groups must be re-quired to accept all comers to pro-tect people with higher risks orpreexisting conditions.

Third, a consumer report cardis too narrow a vision of out-come measures. In addition to“consumer” information, re-form must encourage the rapiddevelopment of sophisticated out-come measures that comparespecific treatments and specificproviders. As Jerome Grossmanand Holmes point out, outcomemeasures and information-tech-nology tools are already improv-ing in anticipation of reform. Thefastest way to spur further ad-vancement is via the widespreaddissemination of measures cur-rently in use.

Hopefully, the consensusamong the respondents regardingthe importance of innovation canbegin to be reflected in the politi-cal debate about the direction ofhealth care and, ultimately, in theplans for its reform.




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Deaconess−Glover Hospital (A)

Case 99© The McGraw−Hill Companies, 2004

Harvard Business School 9-601-022Rev. September 19, 2000

Visiting Scholar John Kenagy, M.D. and Professor Steven J. Spear prepared this case as the basis for class discussionrather than to illustrate either effective or ineffective handling of an administrative situation. Names and financialnumbers have been disguised.

Copyright © 2000 by the President and Fellows of Harvard College. To order copies or request permission toreproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go tohttp://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, usedin a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, orotherwise—without the permission of Harvard Business School.

1

Deaconess-Glover Hospital (A)Hospitals are filled with contradictions. You come to them because you’re sick andneed care, but hospitals are places where infections, uncertainty, and errors mightactually worsen your condition. Yet, miracles happen so routinely that we’ve come toexpect them. Broken bodies are fixed, illnesses are cured, and spirits are repairedbecause of the hospitals’ caregivers. Unlike many business organizations, hospitalsdon’t wrestle with the problem of an uncommitted workforce. You will never see amore motivated group: nurses, doctors, technicians, and administrators. They areinfused with and exude a single-minded desire to comfort and heal, above all else.1

-- Paul O’Neill,Chairman, AlcoaChairman, Working Together Healthcare Initiative ofWestern Pennsylvania

Since August 1999, John Carter, a vascular surgeon, had been working with John Dalton,President of Needham Massachusetts-based Deaconess-Glover Hospital (DGH); JulieBonenfant, Deaconess-Glover’s Vice President for Patient Services; and members of thehospital’s staff (See Exhibit 1 for DGH’s organizational chart). They were seeking anappropriate location within the hospital where they could test the applicability of theToyota Production System2 to the health care setting. The idea was that once a prototypemodel line or learning unit was tested for functionality and its benefits were verified, lessonsfrom the learning unit could be taught throughout the rest of the hospital. The longer-termhope was that once benefits were verified within Deaconess-Glover, lessons from DGHcould be applied within the CareGroup health care system of which DGH was part (SeeExhibit 2 for CareGroup’s organizational chart). Now, in November 1999, Carter wassharing his initial recommendation for the model line. As he waited in Dalton’s office forBonenfant’s arrival, he mentally rehearsed his presentation of findings and supporting dataand anxiously anticipated Dalton and Bonenfant’s reaction.

The stakes were high for all concerned. Carter had a twenty-year career as a vascularsurgeon and as a surgical practice manager in Washington state. However, his experience asa patient proved to be an epiphany. While vacationing with his family, he chased his sonup a tree, slipped on a branch, and fell, breaking the 2nd cervical vertebra in his neck. As apractitioner, he had often wrestled with “the system” to ensure that his patients received

1 Quote taken from e-mail correspondence, January 1999.2 For reference: “Decoding the DNA of the Toyota Production System” by S. Spear and K. Bowen,Harvard Business Review , September/October, 1999.



Case100 © The McGraw−Hill Companies, 2004

601-022 Deaconess-Glover Hospital (A)

2

the care they needed, when they needed it. As a patient, Carter found that the system wasfilled with people who were as highly committed to patient care as he was, if not more so.Time and again, nurses, doctors, aides, technicians, and administrators went to heroiclengths to make sure that he was well treated. Yet, able to see his situation as a patientfrom the perspective of a trained clinician, Carter knew he had experienced many,uncomfortable close calls.

Carter returned from his hospitalization and recovery, looking for a better way tomanage health care. He spent the next five years -- now as an executive in a health caredelivery system -- pursuing better top-down management approaches such as incentivealignment through integrated management systems and exploring public policy options foroversight and regulation. Yet, for all his effort and that of those with whom he worked, hesaw no lasting changes. Finally, he decided to look outside of health care for provenmanagement methods, spending two years in a largely self-funded quest. The work atDeaconess-Glover was his chance to demonstrate the opportunity generated by his twoprevious years of intellectual prospecting.

Dalton and Bonenfant had significant stakes in this process too. Deaconess-Gloverwas a 41-bed community hospital that had lost $2.7 million in the previous 12 months (SeeExhibit 3 for DGH’s summary statements of operations). CareGroup, the 1,500 bed systemof which DGH was part, had lost nearly $100 million in the same period (See Exhibit 4 forCareGroup’s summary statements of operations). CareGroup’s CEO, James Reinertsen,M.D., had enlisted Deaconess-Glover to be CareGroup’s test site, the first facility to learnhow to interpret Toyota Production System principles for the health care context.Reinertsen and his senior management team had been persuaded that if CareGroupmastered Toyota Production System principles, then it might provide higher quality care atlower cost relative to its rivals, just as Toyota had demonstrated sustained and superiorquality, cost, and lead-time over several decades in automobile manufacturing. IfDeaconess-Glover met success, it would become both a showcase and the source of teachersfor the rest of the CareGroup system. There was an added imperative. After volunteeringDeaconess-Glover as the pilot, Dalton and Bonenfant agreed to have a portion of theirincentive compensation tied to the experiment’s outcome.

Reinertsen and Dalton invited Carter into CareGroup and Deaconess-Glover because hebrought two useful perspectives to the exercise. His many years of experience as a vascularsurgeon and as a health care manager meant that the Deaconess-Glover and CareGroupenvironments were familiar to him. In addition, Carter had worked closely with TPSexperts over the previous year. They had helped him view the Toyota Production System asmore than a collection of specific production tools. Rather, he had begun to understand TPSas an integrated approach to designing and improving the work of groups of people engagedin collaborative effort. Carter could now test his understanding of the theory in actualpractice. It was time to see if Carter’s investment of time and Dalton and Bonenfant’swillingness to take a significant professional risk were going to pay off.

Deaconess-Glover Hospital

Glover Memorial Hospital began serving the Needham community as a general-purpose,town-owned facility in 1909. In the 1980s, Glover began to encounter financial difficulty, asdid much of the rest of the health care industry due to the switch from cost-plus paymentsto “Diagnostic Related Groups” which put a cap on the amount hospitals would becompensated per treatment. While medical science and technology had created many more,increasingly complex, and ever more costly tests and treatments, and while demand on the




Deaconess-Glover Hospital (A) 601-022

3

system had increased with a gradually aging, growing population, public and privatereimbursement rates weren’t keeping pace with rising costs.3

To control expenses, the Town hired the Hospital Corporation of America to provideprofessional management. Despite pioneering efforts in Deming-inspired ContinuousQuality Improvement, Glover’s financial situation had not improved sufficiently, however.

Two weeks after joining Glover as its administrator in 1991, John Dalton learned thatthe Town of Needham wanted to privatize the hospital. Since Glover lacked access toneeded capital, and because Glover retained strong support from its staff, its affiliatedphysicians, and the surrounding community, a merger between Glover and a larger hospitalseemed most promising. This was especially true because the health care market in thegreater Boston area was consolidating.

In 1994, Deaconess Hospital, a large, Harvard-affiliated teaching and researchinstitution purchased Glover, agreeing to keep it open for at least five years as part ofDeaconess’s community-based, clinical network. Two years later, Deaconess merged itssystem with that of the Beth Israel Medical Center, another large, Harvard-affiliatedteaching hospital. The combination, named CareGroup, was a 6-hospital network based inEastern Massachusetts, which employed 13,000 people, and had a 2,000 person medicalstaff. Reinertsen, who became head of CareGroup in June 1998, and his senior managementteam were working diligently to make CareGroup the premier system. Yet, it was caught ina sea of external and internal problems that became more intense with almost dailyrevelations in the media about the financial tribulations of the US health care system.

Finding A Model Line

In the first several weeks of his engagement, Carter’s primary objective was to identify asite within Deaconess-Glover that had high potential for a model line. Just as Deaconess-Glover was to be a test site within CareGroup, the model line would be a place where smalltests in applying TPS to health care could be performed. These tests would be the basis forpropagating these discoveries throughout Deaconess-Glover. Carter examined several areaswithin the hospital including the Radiology and Emergency Departments, the Pharmacy,and the Ambulatory Surgery, Gastrointestinal, and the “South Two” medical-surgicalinpatient units. In each, he spoke to members of the staff for a broad overview of what theydid individually and what their unit did overall before making detailed observations of howwork was done in practice.

Gastrointestinal Unit

In the Gastrointestinal unit (GI), Carter met with Dr. Greg Stoller, the gastroenterologistwho performed endoscopies and colonoscopies, Anita Hansen the unit’s senior nurse andmanager, Janice Gibb, a staff nurse, and Hannah Seltzer, an endoscopy nurse.

Beyond talking to the GI staff, Carter directly observed the work of the group byfollowing patients through a medical procedure. In one case, on August 24th, Carter met apatient, Edward Bennett, in the admitting area at 8 AM. Mr. Bennett had been havingtrouble swallowing food and Dr. Stoller was going to use an endoscope to investigate for

3 For reference: “The Structure of the Health Care Industry,” Harvard Business School Publishing,9-196-049, by Ann Winslow and Regina Herzlinger, 1995 and “The Financing of the U.S. HealthCare Industry,” Harvard Business School Publishing, 9-196-095, by Winslow and Herzlinger, 1995.





4

abnormalities in Mr. Bennett’s esophagus and stomach that might explain his symptoms.4Carter followed Mr. Bennett in the prep room, stayed with him during the GI procedure inthe examination room, and joined him in the recovery area where Bennett rested until theanesthesia wore off by 11 AM. Throughout, Carter noted who was doing what and when,trying to record both the physical activities that were occurring and also the informationexchanges that were taking place among the different members of the GI staff and thepatient, on a minute-by-minute basis.

Carter saw that much of the information was situational. For example, some weeksbefore, Mr. Bennett had had a similar procedure performed at a nearby, non-CareGrouphospital. Due to the physical discomfort, uncertainty about the procedure, fear of the painhe might experience, and concern about his condition, based on his previous experience withthe procedure, the 53-year old father of three was extremely anxious on the morning of hisDeaconess-Glover examination. Mr. Bennett’s anxiety caused the medical team to beconcerned with more than his physical condition. His emotional condition was an equallypressing concern, affecting the amount of Valium-like sedative he would need and theamount of agitation for which the team had to be prepared.

After Stoller completed Mr. Bennett’s procedure, Carter observed Hannah5 preparingthe examination room and equipment for the next patient and noted Anita’s procedures foradmitting, discharging, and record keeping. Carter generated a profile of the mix ofprocedures that were performed in the unit and the frequency with which each had beenperformed over the course of that day and that week. The purpose of this was tounderstand better the actual needs of the unit’s patients and the demands these needsplaced on the work group.

This was one of several ways in which Carter’s process of making observationsreflected the professional norms of those with whom he was working. Within the hospital,patient care was repeatedly held up as the primary priority. Similarly, Carter’s TPSmentors routinely observed the work done in factories by starting at the shipping dock.They started there to understand the mix, volume, and timing with which customersexpected to receive deliveries. Understanding customer expectations served as a prelude tostudying how and how well the processes within the plant met customers’ expectations.

South Two Medical/Surgical Inpatient Care Unit

During his initial study across several areas in the hospital, Carter familiarized himselfwith the South Two inpatient care unit. Just as he had tried to understand the working ofthe GI unit on a representative day, he approached South Two in the same way. South Twopatients were either being treated for an illness (medical patients) or were recovering froman operation (surgical patients). The unit had 34 beds. By reviewing unit records, Carterlearned that over the previous month, the “census” had varied between 19 and 31 with anaverage count of 24. Patients could be admitted by one of the more than 100 doctors whohad full staff privileges. Physicians with privileges were allowed to admit patients to thehospital and to provide and to prescribe active care. Though some of the doctors who hadprivileges were employed by the hospital directly, most were part of professional practicesindependent of the hospital. A large portion of these doctors had privileges at more thanone hospital so could admit and treat patients where they saw most fit.

4 An endoscope is a long, narrow, rubber coated instrument with camera lenses on one end andcontrols and video monitor connections on the other.5 The narrative in this case follows the hospital’s convention by which nurses go by their firstnames, doctors by their professional title and surname, and patients by their title and surname.





5

On August 24th, Carter arrived at Deaconess-Glover at 6:45 AM so that he couldobserve the end of the night shift (11 PM - 7 AM) and the beginning of the day shift (7 AM -3 PM). He joined the nurses in their break room from 7 AM to 8 AM. There, the three night-nurses reported on patient conditions to the five day-shift nurses.

Carter learned from the nurses that while they were in the hospital, patients wereusually visited by their doctors twice in a day, during morning rounds and during eveningrounds. The bulk of the patients’ 7-day, 24-hour ongoing care was provided by SouthTwo’s nurses. Organized in three shifts, the nurses assessed patients’ conditions,developed care plans, and administered medications and other treatments. They alsoevaluated results, responded to emergencies, changed dressings, helped with meals, bathedpatients, and provided the support and information patients and their families neededduring what was a stressful experience. According to the unit’s staffing charts, the typicalday shift (7 AM to 3 PM) had five nurses, the evening shift (3 PM to 11 PM) had four, andthe night shift (11 PM to 7 AM) had three. Carter saw that staffing levels on each shift hadbeen adjusted based on the number of patients and the severity of each patient’s condition.Because of days off, part time work loads, vacations, and sick days, the number of nursesassociated with South Two was actually double to triple the daily staffing level.

The day shift began when Arlene Wassel, the day-shift “charge nurse,” assigned each ofthe 26 patients to one of the five day-nurses. (“Charge nurse” was not an official managerialposition. Rather, responsibility for making assignments was circulated among the moresenior nurses on an informal basis.) Working from a patient roster and from her ownknowledge of each patient’s condition, Arlene assigned patients to nurses based on eachnurse’s skill and interests and based on the acuity of each patient’s needs. For instance,some nurses tended to be more comfortable with medical patients while others preferred towork with surgical cases.6 Arlene explained that she knew many of the patients becausethey had been on the unit the previous day (average stays were about 4 1/2 days).However, before making assignments, she gathered information about those who had beenadmitted during the evening and night shifts.

After Arlene made assignments, the night nurses began to exchange information withthe day nurses for the purposes of assessment and treatment. While the patients’ medicalcharts contained quantitative information, there were unique anecdotal factors that were notcommunicated on standardized forms. For example, two nurses discussed Mr. Howard’ssituation.

A veteran of World War II, Howard had run a family-owned hardware store inNeedham for thirty-seven years, raised a family, and was a long time Boy Scout leader.Recently, suffering from progressive dementia, the nursing home resident had been havingtrouble eating. This had left him weak, dehydrated, and in need of more active care thanthe nursing home could provide. In addition to his medical issues, the night-nurse, Diane,explained to her day-shift replacement that Mr. Howard kept misplacing his box of Tic-Tacs®, and this caused him anxiety and mild distress. Furthermore, Diane had realizedthat he only had one candy left. She tried the vending machine, but it didn’t sell the mints.Diane called a day-shift colleague who bought a supply on her way to work. Dianeexplained that she had put the Tic-Tacs® under Mr. Howard’s pillow so that he could findthem easily.

Carter saw that during the hour, nurses repeatedly left and returned to the room inwhich report was being given. He followed several nurses and realized that even during

6 Before Dalton joined Glover Memorial, the surgical care unit and the medical care unit had beenseparate entities.





6

report, they continued to care for patients. In one instance, a day nurse, Cindy, respondedto an equipment buzzer. A pump that provided painkiller intravenously to a post-operative patient, Mrs. Gould, had stopped and needed to be reset.

After the night-shift finished its report, the day nurses reviewed the specific needs foreach patient in the KARDEX, a loose-leaf binder containing a sheet for each patient thatoutlined treatment requirements such as dressing changes, special feeding instructions, etc.Each nurse made notes on a “cheat sheet” that she carried as reference throughout the day.7

After the morning report, Carter spent 30 minutes observing the front desk nurses’station. Here, doctors and nurses reviewed and modified patients’ charts, Denise -- the unitsecretary -- took calls, social workers reviewed records, and doctors phoned in instructionsthat had not been communicated during rounds. For example, after making her own rounds,a nurse had phoned the admitting-physician with questions about a patient’s treatment.Carter watched as the receptionist received the return call from the physician and found thenurse who had made the request.

On a second visit to South Two, Carter observed activity in the five-foot by seven-footMedication Room. Each patient had an individual drawer or cassette in which a day’sworth of medication was kept. Each cassette was stored in one of two cabinets on wheels,and with each cabinet was a loose-leaf binder that contained the MedicationAdministration Record (MAR) for each patient. Carter saw that nurses would come to the“med room,” transfer information from the MAR to their cheat sheets, and then stagedosages of several medications that had to be administered at the same time in a disposablepaper cup. For instance, when asked what she was doing, one nurse explained that she wasputting together all the medications that had to be given at 9 AM in one cup, and all thosefor 1 PM in another. While nurses were “pouring meds,” as this activity was called, othernurses would look in, and if the room was crowded, they would move onto another activitybefore returning to do their own medication staging.8

The Pharmacy

Carter also made observations in the pharmacy as he initially familiarized himself withDeaconess-Glover. On September 8th, at 8 AM, he met Denise, the pharmacy technician,Carol -- one of the registered pharmacists, and Dan Carpenter, also a registered pharmacistand the unit’s manager. Carter started by watching Denise prepare intravenous medicationsfor patients in both South Two and also in the Intensive Care Unit.

Denise reviewed medication orders sent to the pharmacy on “Green Sheets.” Sheexplained that each Green Sheet was the 3rd copy of an order written by a doctor duringrounds or by a nurse after discussing a patient’s condition with a doctor on the phone. TheGreen Sheet had information for a new or modified prescription. For those who had been atDeaconess-Glover the day before, Denise modified the Pharmacy’s Patient’s MedicationRecord (PMR) for intravenous medications. For those admitted during the evening or nightshift, Denise created a new PMR. Using each patient’s PMR for reference, Denise labeled

7 On a separate visit, Carter observed another shift-change activity, counting the narcotics lockedin South Two’s medication room. A nurse completing a shift and a nurse starting on the next shiftreviewed the entire narcotics inventory and compared that to the narcotics-use record. No nursecould leave until all narcotics issues were reconciled and verified. Once the counts were reconciled,a “White Sheet” was completed and sent to the pharmacy.8 Carter noted variation in this activity. Some nurses staged medications for the entire day,whereas others returned to the Medication Room every two hours for the next round of doses.





7

the medications and staged them on a cart for delivery that day. As she took the IVs fromthe freezer, refrigerator, or cabinet where they were stored, she noted those for which theinventory was running low so that a replenishment order could be made later that day.

After watching Denise perform her work, Carter observed Carol do her work. Shestarted by updating a separate set of Patient Medication Records based on Green Sheetsthat had been delivered to the pharmacy during the evening and night shifts. Then, at 10AM she left the pharmacy and went to South Two’s medication room to reconcile her PMRswith the Medication Administration Records kept there. After returning to the pharmacy,she began withdrawing dosages for each patient from one of the 600 containers that werekept on three shelves -- each fifteen feet long, and placed these blister-pack wrapped pillsand tablets in the patient’s cassette along with other prescribed medications such as eyedrops and syrups.

In several cases, Carol had to inform nurses that a particular medication needed specialattention. For example, in watching Carol do her work, Carter learned that the pharmacyhad 20 mg tablets of a certain drug, but the physician had prescribed a 10 mg dose. Carolaffixed a red adhesive label to the pill’s blister pack so that the nurse would know she hadto divide the tablet in half before giving half to the patient and disposing of the other half.Carol said that she was trying to complete the filling of all the cassettes by 1:00 PM so thatshe could wheel two cassette carts to the medication room in South Two and another to theintensive care unit and collect the previous day’s carts.9

Medication Administration on South Two

After this overview of the hospital, Dalton, Bonenfant, and Carter decided to focustheir efforts. They chose not to concentrate on a particular department or unit -- Radiologyfor instance -- but instead opted to test the application of the Toyota Production System toa specific process, medication administration, in the South Two inpatient-care unit.

Medication administration was the process that delivered pharmaceuticals to patientson a seven-day, 24-hour per day basis. Carter noted that on October 28 South Two’s 23patients required as few as three and as many as 17 medications (See Exhibit 5 and Exhibit6). The drugs varied by physical form (pills, tablets, intravenous solutions, topicals, etc.),by administration timing (every 2, 4, 8, 12, 24, or 48 hours or on an as needed basis), and byother criteria (i.e., with or without food). Carter had learned from his earlier observationsthat several people were involved in the prescription, delivery, and administration of thedrugs, and in the pre-treatment and post-treatment evaluation of the patients. Theseincluded nurses, doctors, pharmacists, and technicians with various specialties.

Though medication administration crossed the boundary of two areas of the hospital --the pharmacy and the medical/surgical recovery unit, it offered several advantages for thepurposes of the TPS implementation experiment. Medication administration directlyaffected the quality and cost of patient care. Mis-medication could delay or compromise apatient’s well being, yet the process didn’t automatically work well. National studiesestimated that getting the prescribed medication to patients in the correct form and

9 The pharmacy delivered several classes of medications. One group included those supplied on apatient by patient basis, such as those just described. Second were narcotics delivered in response to“White Sheet” orders. Other medications were supplied on a restock basis, and were ordered on“Pink Sheets,” department by department. In South Two, for instance, certain saline solutions werestocked in the medication room so they would be available immediately as needed.





8

quantity, and at the right time, had error rates in the parts per hundred. 10 To reduce theerror problem, computerized prescription tracking and drug dispensing technologies werebeing installed across the country, and CareGroup was an early adopter of these in some ofits facilities.

Material and Information Flows: Day-Shift

Once South Two had been picked as the site for the learning unit, Carter studied themedication administration process more closely. His TPS mentors had emphasizedrepeatedly that before he made any changes he had to understand the “current condition,”how the process actually worked. As a first step, he had to know what goods and serviceswere provided to the patient, and how the organization produced and delivered each ofthese goods and services. To gain this information, Carter waited at a patient’s room untilthe patient’s nurse came to administer medication. After the patient received the variousdoses, Carter asked the nurse how she had been supplied. He learned that the nurse hadtaken two medications from the patient’s cassette which was stored in the medication cartin the medication room. A third medication had been delivered directly to the nurse by thepharmacist an hour earlier. Since he had already observed the pharmacy’s work during theearlier portion of his study, Carter knew that the medication cart was delivered once perday to South Two and that throughout the day, the pharmacy made additional deliveriesbecause of changes in patient medications created by new prescriptions.

Having made observations that established from whom to whom and from where towhere medication was transferred on its journey from the pharmacy to patient, Carter thenbegan a second step in grasping the current condition. He had determined the basic flows ofmaterial characteristic of the medication administration process. Now Carter tried todetermine the basic information flows characteristic of the process, trying to determine howpeople knew what to transfer, to whom, when. Therefore, as his second step in grasping thecurrent condition, Carter followed an order from when it was prescribed until when it wasdelivered. He did this by following a doctor during rounds until the doctor revised apatient’s prescription. This first occurred at 8:10 AM. Carter continued to follow thedoctor through the rest of her rounds and to the nurse’s station. There, she wrote the neworders into the patient’s chart. 11

Next, Carter watched how that specific medication order was actually picked up anddelivered. The patient’s nurse saw the physician fill out the medication order sheet, so shewent immediately to the chart and separated the medication order into its three parts. The

10 According to the report To Err Is Human : Building a Safer Health System , medical errors k i l l44,000 to 98,000 people in U.S. hospitals each year, a total greater than the deaths attributed tohighway accidents, breast cancer or AIDS. Medication errors specifically are responsible for 7,000deaths per year, more than those due to workplace injuries. -- From the press Release for To Err IsHuman: Building a Safer Health System ; L. Kohn, J. Corrigan, and M. Donaldson, Editors;Committee on Quality of Health Care in America, Institute of Medicine; 200011 The patient “chart” was a large, maroon, three ringed binder and served as a primary mediumthrough which doctors and other health team members communicated. For example, if the doctorexamined a patient and decided the patient needed to get a particular medication every four hours,the doctor would write that instruction in this three-ring binder and would then put the binder backon the shelf.





9

top copy remained in the chart, the middle copy was pasted into the MAR, and the thirdcopy, the Green Sheet, was sent to the pharmacy. 12

Carter observed that the Green Sheet for this particular order was placed in the nursingstation’s outbox, and a few minutes later, it was collected by Denise, the pharmacytechnician. At the same time, another nurse reminded Denise of a different patient who hada change in medication requirements. Carter trailed Denise to the Intensive Care Unit, andthen back to the pharmacy where she gave the Green Sheet at 9 AM to Carol who was in themidst of dispensing medications. Since the drug was needed before the filled medicationcart was to be delivered to South Two’s medication room, Carol placed the requested drugdosage in a plastic bag that was labeled with the patient’s name and the drug’s names. Shegave this bag to a community volunteer who came to the pharmacy at 10:15 AM to take itback to nursing station inbox at South Two. There, the nurse collected the medication fromthe inbox at 10:30 AM and gave it to the patient at 10:35 AM.

Having followed one medication from when it was prescribed at the patient’s bedsideuntil it was administered to the patient, Carter followed a second prescription.

Mrs. Donaldson, one of Dr. Whestney’s patients, was complaining of gastrointestinalsymptoms, for which Whestney prescribed a 20 milligram dose of Prisolec. Whestney didthis by completing an order sheet and adding it to the chart. A few minutes later, Mrs.Donaldson’s nurse, Arlene, read the new instructions and placed the Green Sheet copy inthe outbox and also started to add the order to the patient’s Medication AdministrationRecord. As she was recording this information in the MAR, she realized -- based on herconsiderable experience -- that Prilosec was no longer part of the hospital’s formulary andthat it been replaced by Previcid, which was available in 15 milligram doses. 13

Though the Green Sheet had been collected, Arlene found Miriam, another pharmacist,who had come to South Two to reconcile the pharmacy’s Patient Medication Record withSouth Two’s Medication Administration Record. Miriam offered to return with two tabletsof Previcid so that if Dr. Whestney wanted either 15 mg or 30 mg given to Mrs. Donaldson,Arlene would be prepared. In the meantime, Arlene called Dr. Whestney, confirmed that 15mg was sufficient, and so was able to administer the drug to the patient at 9 AM whenMiriam returned to South Two.

Summary of Findings

After watching how the medication administration process occurred in actual practice,Carter summarized his findings in a hand-drawn diagram (the version for South Two’s dayshift is replicated in Exhibit 7). He started by indicating the different participants in theprocess: the patient, the doctor, the nurse, the pharmacist, and the volunteer. Then, heindicated who communicated with whom and the way in which information wascommunicated. For example, his diagram captured the observation that doctors learnedabout patients’ conditions by direct examination during rounds or from information

12 Carter observed several ways in which nurses knew that something has been changed in thechart. The doctor “flagged” the chart by flipping the color tag on its spine from green to red; thedoctor verbally told the patient’s nurse that a change had been made; or the nurse went to check i fthere was anything new in the book even if the flag-color had not been changed.13 The medications kept in stock comprised the hospital’s “formulary.” Because identical drugsexisted with different brand names, and because different drugs might have had identical uses, i twas possible for a doctor to prescribe a medication that was not in the formulary, and so was notavailable in-house.





1 0

gathered by nurses and communicated in medical charts, by face to face verbalcommunication, or by phone. Carter included in his diagram his observations thatinformation about prescriptions was communicated from doctors to nurses throughinformation in the chart, in face to face conversation, or over the phone. He added thedifferent ways in which the pharmacy learned that a patient needed medication. Theseincluded the various forms such as Green Sheets for specific prescriptions, White Sheets fornarcotics orders, and Pink Sheets for medications kept in stock in South Two. He addedthe face-to-face and phone conversations that he had noted, and also the PMR/MARreconciliation done by Carol, the pharmacist, each morning and the calls the pharmacymade to South Two for clarification of a hard-to-read Green Sheet entry.

Having indicated how requests were communicated between those who neededsomething and those who would provide it, Carter then showed how suppliers responded.His diagram showed that medications arrived to South Two from the pharmacy in themedication cart, through the efforts of a volunteer, or when a pharmacist came to the floor,as Miriam had done with Mrs. Donaldson’s Previcid. Carter’s illustration showed thecomplete loop by indicating that it was the nurse who administered each medication.

Carter’s detailed description of South Two’s medication and information flows showedwho was involved in the medication administration process, what each person wasexchanging/communicating with the other, where these exchanges took place, and how theywere exchanging medications and communicating information. Because these informationflows contained instructions of what to do, the diagram suggested why people did certainactivities. The final element of the diagram indicated the time element, when eventsoccurred. Carter indicated when the doctor examined the patient, when the prescriptionwas entered in the chart, when the Green Sheet was detached and placed in the outbox,when the sheet was picked up and delivered to the pharmacy, etc. on the drawings he madefor each specific medication administration observation.

Medication Administration: Evenings and Nights

For both the evening and night shifts, Carter repeated the process of following amedication from when it was prescribed until when it was administered. He discovereddifferences in the nature of orders made during these shifts and how orders werecommunicated to the pharmacy and how a delivery was made back to South Two.

The nature of the orders differed in the following way. During the day, the pharmacyprepared the patient-cassettes with a day’s worth of medication. During the evening andnight shifts prescriptions were for newly admitted patients or were adjustments in themedication for a continuing patient. In both cases, medication delivery was for severalhours, not for an entire day. The form in which orders were handled differed because thepharmacy was not staffed during evening and night shifts. Therefore, it was theresponsibility of the shift’s nursing supervisor to bring Green Sheets to the pharmacy anddistribute the ordered medications to South Two. The Green Sheets were left until the nextday, at which point the information was transferred into the PMR. The medication wascarried back to South Two by the nursing supervisor so that it could be administered to thepatient. Beyond the description just given, these differences are not detailed further in thiscase. However, as part of Carter’s effort to understand the medication administrationprocess, he generated a separate set of summary diagrams and analysis.

Observing the Work of a Nurse

In tracking medications from when and where they were prescribed to when and wherethey were administered, Carter identified each person who had played a role. Therefore, he





1 1

was able to document the particular pathway over which specific prescriptions traveled.He was also able to observe how information and materials were exchanged among themembers of the health care team. In an additional set of observations, Carter sought tolearn about the work of the specific people who played a role in the process as part of hislarger effort to grasp the current condition of medication administration. He approachedthis portion of the study by following an individual nurse for 60 minutes and recording -- ona minute by minute basis -- where she was, what she was doing, with whom she was working,and what was being said. (Exhibit 8 displays the table Carter generated from observing onenurse on the day shift). To be sure that his observations were representative, Carterrepeated this activity with another day-shift nurse and with nurses on the evening and nightshifts. He then shared his findings with the nurses he observed and with other members ofthe nursing staff to confirm the validity of his observations and the way he had representedthem.

Carter’s impression, which was confirmed when he reviewed his detailed records of hisobservations, was that the nurses were blizzards of activity. For example, the nurse whosework is documented in Exhibit 8, cared for five patients in three rooms during her shift. Inthe hour that Carter observed her, Cindy worked in eight locations (patient rooms 237, 238,and 239; the hall phone, the kitchen area, the nurses’ station, the medication room, and thesupply closet). In the hour, she moved among these 8 locations 22 times, and she spoke in-person or on the phone with 15 different people. For example, she spoke with the fivepatients for whom she was caring, both to assess their condition and to provide informationand reassurance. Cindy discussed the condition of an elderly patient with the patient’sdaughter, explaining the follow up home care the mother would need after being dischargedfrom the hospital. Cindy traded information with five other South Two nurses, a hospicenurse, and a nursing aide. She also spoke by phone with two doctors and their receptionistsin order to get clarity on the treatment two patients were to receive.

Carter asked the South Two nursing staff to define the function of a nurse and theyuniformly described it as “assessing a patient’s needs, developing a care plan, implementingthe care plans, administering treatments, evaluating the results, and otherwise attending tothe care of the patient.” In reviewing his minute by minute observations, Carter noted thatin the hour he had recorded, the nurse had spent two thirds of her total time locatinginformation and gathering the materials necessary to do the value-adding nursing work thatwas described as a nurse’s job. Carter found that all the nurses he observed spent betweenone-half and two-thirds of their time occupied by other activities that were necessary to dovalue added nursing. To communicate these findings to other people, Carter summarizedhis observations in hand-drawn diagrams that are reproduced in Exhibit 9.

Completing the Current Condition: Who Cares for Whom?

In his first step at understanding the current condition of the medication administrationin South Two, Carter had traced specific pathways over which prescriptions andmedications traveled, documenting flows of information and medication among thosemaking requests and those generating responses. That resulted in the diagram in Exhibit 7.In his second step at understanding the current condition, Carter studied the work ofindividuals who performed activities on the pathway over which prescriptions andmedications traveled.15 In the third and final step of understanding the current condition,Carter tried to determine the number of distinct pathways over which prescription requestsand medications traveled. To do this, he obtained the sheet on which nursing assignmentswere recorded. This document, reproduced in Exhibit 10, showed each patient (indicatedby room number), the patient’s doctor, and the nurse on each shift -- day, evening, and night

15 Activity studies were done in the pharmacy, though they are not reproduced in this case.





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-- who was assigned to that particular patient. Carter re-expressed that documentdiagrammatically, as in Exhibit 11. He did this to show, pictorially, who had to speak withwhom about a patient’s condition, not only during a shift but across shifts as well.

Recommending a Next-Step

Carter had consolidated his findings on an 11x17 sheet of paper for the meeting withDalton and Bonenfant. He included background information about the underlying businesscase for CareGroup, Deaconess-Glover, South Two, and the medication administrationprocess, and included the three summary diagrams he had developed. (See Exhibit 12)Carter used this document to explain to Dalton and Bonenfant how he had studiedmedication administration and what he and the front line team had observed. He explainedthat he had confirmed his observations with members of the nursing and pharmacy staff.Though the presentation was punctuated by questions, neither Dalton nor Bonenfant tookexception to Carter’s description of how this critical patient-care process actually occurred.

Carter was bolstered by their evident interest in what he had done and their obviousagreement with his findings. After thirty minutes, Carter concluded the first portion of thepresentation. He then drew in his breath and began explaining the next step he and the TPSexperts had designed. Eager to learn Dalton and Bonenfant’s reaction, Carter presented thediagram for the “target condition,” the first step for implementing the Toyota ProductionSystem in South Two’s medication administration process.




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601-

022

-16-

Exh

ibit

4: C

onso

lid

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Sta

tem

ents

of

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601-

022

-17-

Exh

ibit

5: M

edic

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ns

pre

scri

bed

for

eac

h p

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nt

in S

outh

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o on

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601-

022

-18-

Exh

ibit

6: M

edic

atio

ns

pre

scri

bed

in

Sou

th T

wo:

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601-

022

-19-

Exh

ibit

7: M

edic

atio

n A

dm

inis

trat

ion

- S

outh

Tw

o -

Day

Sh

ift:

Flow

s of

Med

icat

ion

an

d I

nfo

rmat

ion

-

Doc

tor

Sout

h

Tw

o

Nur

se

Phar

mac

y

Cha

rt

Ver

bal

Phon

e

Ver

bal

Phon

e

Cha

rt

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en

Shee

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one

Pink

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te

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Vol

unte

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Med

C

art

Spec

ial

Del

iver

y

Info

rmat

ion

Med

icat

ion

Dru

g gi

ven

ac

cord

ing

to

pres

crip

tion24

hr/

7day

nu

rsin

g ca

re

Pati

ent In

form

atio

n:

Re q

uest

s, c

lari

fica

tion

s

Med

icat

ion

del

iver

ies

Ela

psed

tim

e fo

r re

ques

ts

Ela

psed

tim

e fo

r re

spon

ses

Phon

e R

ecep

-ti

onis

t

Phon

e

Ver

bal

2x/

day

ph

ysic

ian

exam

8:10

AM

Pres

crip

tion

w

ritt

en

10:3

5 A

MM

edic

atio

n gi

ven

to p

atie

nt

9:00

AM

Gre

en s

heet

d

eliv

ered

to

phar

mac

ist

Rec

onci

liati

onPa

tien

t Med

icat

ion

Rec

ord

/M

edic

atio

n A

dm

inis

trat

ion

Rec

ord

10:0

0 A

M

Vol

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ves

med

icat

ion

10:1

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M

Med

icat

ion

left

in

Sout

h T

wo

in-b

ox

10:3

0 A

M

Nur

se ta

kes

m

edic

atio

n fr

om

in-b

ox




601-

022

-20-

Exh

ibit

8: E

xam

ple

: Day

-Sh

ift

Nu

rsin

g A

ctiv

itie

s -

Nov

emb

er 3

, 199

9, 9

:15

- 10

:15

Tim

eW

her

eW

hat

Wh

oS

ayin

g w

hat

9:15

Hal

lway

pho

nePh

onec

all P

harm

, hun

t med

Is th

is v

acci

ne o

k?M

edic

atio

n R

oom

look

for

syri

nge,

dra

w la

bel v

acci

neA

rlen

e, R

osie

Is th

is v

acci

ne o

k?R

oom

239

look

for

pat

ient

Nur

se’s

Sta

tion

labe

l syr

inge

Med

icat

ion

Roo

mpu

t syr

inge

in fr

idge

. Fin

d 1

0 m

eds

9:20

pull

MA

R S

heet

s fo

r d

isch

arge

RN

1U

sing

MA

R?

Roo

m 2

38gi

ve m

edw

ith

pati

ent

in 2

38G

reet

ing,

giv

e m

ed, r

ecei

ve r

eque

stki

tche

nge

t jui

ceR

oom

238

deliv

er ju

ice

wit

h pa

tien

t in

238

Man

y qu

esti

ons

from

pat

ient

.le

aves

med

, fin

ish

bath

, cha

nge

isol

atio

n p

reca

uti

ons?

,9:

25be

d, s

trai

ghte

n ro

om, e

tcgo

ing

hom

e, m

eds,

bat

h w

hen,

etc

.A

sks

ques

tion

s of

pat

ient

“Did

you

use

you

r in

hale

r?”

9:30

Supp

ly &

Med

Roo

mW

ash

hand

s, g

et fl

u sh

ot a

ndR

oom

237

supp

lies,

giv

e fl

u sh

ot, r

emov

ew

ith

pati

ent

in 2

37E

xpla

ins

flu

shot

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IV

pati

ent’

s IV

rem

oval

, ans

wer

que

stio

nsab

out d

isch

arge

obse

rve

site

for

blee

ding

9:35

Supp

ly &

Med

Roo

mw

ash

hand

s, g

et M

AR

she

ets

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se’s

Sta

tion

for

tran

sfer

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t for

cha

rtA

ide

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re’s

cha

rt?

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m 2

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ide

Hel

p ro

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pat

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s ha

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pat

ient

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olog

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9:40

Nu

rse’

s St

atio

nSt

arts

ref

erra

l for

ms

and

pro

cess

Ans

wer

s ph

one

Aid

eph

one

call

Hos

pice

RN

conc

erns

abo

ut

pati

ent’

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atu

san

d m

eds,

Fam

ily h

as w

orri

esge

ts s

ugge

stio

n fo

r ne

w m

ed9:

45C

all M

Dre

cept

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st 1

MD

at

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rof

fice

Cal

l ano

ther

off

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rece

ptio

nist

2 f

ind

MD

Tal

k to

MD

MD

expl

ain

hosp

ice

conc

erns




601-

022

-21-

get n

ew m

ed o

rder

by

phon

eA

nsw

ers

phon

eIn

teco

m -

call

anot

her

RN

toth

e ph

one

9:50

Find

’s p

atie

nt’s

cha

rt, s

tart

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rite

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here

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hart

?or

der

s, in

terc

om a

gain

, fin

ish

Aid

ed

oes

inte

rcom

wor

k?or

der

, rep

lace

cha

rtM

edic

atio

n R

oom

Post

new

ord

erP

harm

acis

tE

xcus

e m

e, a

sks

abou

t new

obse

rve

“was

tes”

nar

coti

cR

N 2

med

, was

te n

arco

tic?

9:55

Nu

rse’

s St

atio

nB

ack

to t

rans

fer

char

t fo

rmR

N 3

apol

ogiz

e fo

r ke

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g he

r w

aitin

g

phon

e ca

llA

ide

“You

hav

e ph

one

call”

Pt’s

dau

ghte

r -

conc

erns

from

hosp

ice,

clar

ific

atio

n, r

eass

uran

ce10

:00

Dis

cove

rs n

ew m

ed o

rder

on

the

tran

sfer

ing

pati

ent,

chan

ge fo

rm,

sign

off

ord

er, r

ecor

ds

med

“gi

ven”

10:0

5

Med

icat

ion

Roo

mG

et a

bove

med

from

floo

r st

ock

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m 2

37G

ive

abov

e m

edw

ith

pati

ent

in 2

37M

any

ques

tion

s ab

out t

his

med

Nur

se’s

Sta

tion

Find

cha

rt, r

evie

w o

rder

, che

ckpa

tien

t bel

ieve

s d

osag

e in

corr

ect

10:1

0la

b to

see

if d

ose

app

rop

riat

e,ch

eck

disc

harg

e or

der

Roo

m 2

37R

emem

bers

som

ethi

ng o

n di

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form

wit

h pa

tien

t in

237

Rea

sure

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se’s

Sta

tion

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ck c

hart

10:1

5R

oom

237

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es m

edw

ith

pati

ent

in 2

37A

nsw

ers

man

y qu

esti

ons,

conv

ince

s pa

tien

t th

at it

is o

k to

tak

em

ed




601-

022

-22-

Exh

ibit

9: S

um

mar

y of

on

e-h

our

of n

urs

ing

acti

vity

Sout

h T

wo

Nur

sePa

tien

t

In o

ne h

our

. . .

• 8

loca

tion

s•

22

loca

tion

cha

nges

• 1

5 co

nver

sati

on p

artn

ers

• 2

5 to

pics

• 5

pat

ient

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Making Competition in Health Care Work


Making Competition inHealth Care Work

by Elizabeth Olmsted Teisberg, Michael E. Porter, and Gregory B. Brown

Reprint 94408





JULY-AUGUST 1994

Reprint Number

HarvardBusinessReviewCHRIS ARGYRIS GOOD COMMUNICATION THAT BLOCKS LEARNING 94401

ROBERT H. WATERMAN, JR., TOWARD A CAREER-RESILIENT WORKFORCE 94409JUDITH A. WATERMAN, ANDBETSY A. COLLARD

ROSABETH MOSS KANTER COLLABORATIVE ADVANTAGE: THE ART OF ALLIANCES 94405

PAUL KRUGMAN DOES THIRD WORLD GROWTH HURT 94406FIRST WORLD PROSPERITY?

GARY HAMEL, C.K. PRAHALAD COMPETING FOR THE FUTURE 94403

ELIZABETH O. TEISBERG, MAKING COMPETITION IN HEALTH CARE WORK 94408MICHAEL E. PORTER, ANDGREGORY B. BROWN

HBR CASE STUDYSANDI SONNENFELD MEDIA POLICY – WHAT MEDIA POLICY? 94407

PERSPECTIVESTHE CHALLENGE OF GOING GREEN 94410

SOCIAL ENTERPRISEREGINA HERZLINGER EFFECTIVE OVERSIGHT: A GUIDE FOR

NONPROFIT DIRECTORS 94404

WORLD VIEWBENJAMIN GOMES-CASSERES GROUP VERSUS GROUP: 94402

HOW ALLIANCE NETWORKS COMPETE




HARVARD BUSINESS REVIEW July-August 1994 Copyright © 1994 by the President and Fellows of Harvard College. All rights reserved.

Health care reform in the United States is on acollision course with economic reality. Most pro-posals focus on measures that will produce one-time cost savings by eliminating waste and ineffi-ciency. The question at the heart of the currentpolitical debate is whether these savings will belarge enough to pay for the added costs of universalcoverage. But this is the wrong question to ask if re-formers are serious about achieving a lasting curefor U.S. health care.

The right question, and one that is conspicuouslymissing from the health care debate, is how toachieve dramatic and sustained cost reductionsover time. What will it take to foster entirely newapproaches to disease prevention and treatment,new ways to deliver services, and more cost-effec-tive facilities?

The answer lies in the powerful lessons businesshas learned over the past two decades about the im-peratives of competition. In industry after industry,the underlying dynamic is the same: competition

compels companies to deliver increasing value tocustomers. The fundamental driver of this continu-ous quality improvement and cost reduction is in-novation. Without incentives to sustain innovationin health care, short-term cost savings will soon beoverwhelmed by the desire to widen access, thegrowing health needs of an aging population, andthe unwillingness of Americans to settle for any-thing less than the best treatments available. In-evitably, the failure to promote innovation willlead to lower quality or more rationing of care –twoequally undesirable results.

Incentives throughout the health care system are so skewed thatthe normal rules of competition do not apply.

by Elizabeth Olmsted Teisberg, Michael E. Porter, and Gregory B. Brown

Elizabeth Olmsted Teisberg and Michael E. Porter areassociate professor and professor, respectively, at theHarvard Business School in Boston, Massachusetts. Gregory B. Brown, a former surgeon, is a vice presidentof Vector Securities International in Chicago, Illinois.The three have recently completed a three-year studythat examines the competitive dynamics of health care,Innovation, Information, and Competition: A LastingCure for U.S. Health Care.

Making

Competition in

Health Care

Work




HEALTH CARE COMPETITION

132 HARVARD BUSINESS REVIEW July-August 1994

The misguided assumption underlying much ofthe debate about health care reform is that technol-ogy is the enemy. By assuming that technologydrives up costs, reformers neglect the central im-portance of innovation or, worse yet, attempt toslow its pace. In fact, innovation driven by rigorouscompetition is the key to successful reform. Al-though health care is unique in some ways, in thisrespect, it is no different than any other industry.The United States can achieve universal access andlower costs without sacrificing quality, but only byallowing competition to work at all levels of thehealth care system.

What’s Wrong with Competition inHealth Care?

More health care competition exists in the Unit-ed States than in any other industrial nation. Thepuzzle confounding reformers is that while compe-tition has been enormously successful at producingquality-enhancing innovation, it appears to havefailed on the crucial dimension ofcost. A closer look suggests not thatcompetition is failing, but that in-centives throughout the system havebeen so skewed that the normalrules of competition simply do notapply. Prices remain high even whenthere is excess capacity. Technolo-gies remain expensive even whenthey are widely used. Hospitals andphysicians remain in business evenwhen they charge higher prices for equal quality orfail to provide high-quality service. Until recently,incentives existed only for innovations that raisedcosts or increased quality regardless of cost.

Successful reform must begin with a clear under-standing of how the current system creates incen-tives for unproductive competition.

Payers’ Incentives Make Payers Adversaries of Patients and Providers

In most industries, the consumer makes the pur-chasing decision and pays for the product or service.In health care, the purchasing decision, payment,and receipt of services are separated. As a result,there are multiple tiers of customers: employers,who purchase health care coverage for their em-ployees; third-party payers, such as insurance com-panies and health maintenance organizations(HMOs), which collect premiums and then payproviders for services rendered to their subscribers;patients, who ultimately receive the health care

services; and doctors, who determine or advise onthe tests and treatments for patients.

These customers have different interests. Theemployer is concerned with paying the lowest pre-miums while providing enough insurance to retainemployees or meet contractual obligations. Thethird-party payer is concerned with spending lesson patient care than was received in premiums. Theinsured patient is concerned with finding the bestquality care regardless of cost. And the advisingdoctor often has incentives to order more services.

Since payers do not have the final legal responsi-bility for insured patients’ bills, patients are thepayers of last resort. The conflict of interest be-tween payers and patients creates incentives forpayers to compete on the basis of creative and com-plicated methods of denying coverage to peoplewho might need expensive care. The payer becomesthe patient’s adversary, rather than advocate, deny-ing payment on claims whenever possible. The in-centives not to pay claims also set the payer in op-position to the provider by requiring the provider to

assume the costs that neither payer nor patient haspaid. As a result, providers expend scarce resourceson bill collection and avoid patients whose insur-ance companies may deny claims. These skewedincentives lead to behaviors that get in the way ofgenuine cost reduction.

However, the conflict among payers, patients,and providers is unnecessary. Payers should be ableto profit only from actually improving the qualityof medical outcomes and reducing costs, not fromshifting payment responsibility onto patients orproviders. They should concentrate on identifyinghigh-quality providers with good medical out-comes and negotiate lower prices for their services.Studies show that better quality care is often lowerin cost due to the efficiency of experienced medicalteams, fewer complications, and better long-termresults.1 For example, The Prudential InsuranceCompany of America estimates that it saves morethan 20% in costs with its Institutes of Quality Pro-gram by directing bone-marrow transplant patientsto high-quality providers, which are screened on

Until recently, incentives existedonly for innovations

that raised costs or increasedquality regardless of cost.




HARVARD BUSINESS REVIEW July-August 1994 133

the basis of the limited available data on facilities,staff, credentials, processes, and past outcomes. Recent programs like this one are productive re-sponses to new pressures to find ways to reducecosts, not just avoid paying claims.

Patients’ Incentives Discourage Cost Sensitivity

In life-threatening or urgent situations, patientsand their families are rarely price sensitive. Buteven when it comes to receiving routine and discre-tionary services or choosing a health plan, most pa-tients have had little incentive to consider cost. Patients rarely have access to relative price infor-mation; they rarely comparison shop; and they of-ten feel uncomfortable asking about prices for fearof offending the physician on whom they rely.

In fact, most employees choose insurance planswithout considering price. Sometimes employeesdo not pay at all for their health benefits. Othertimes the prices of competing plans are equalizedby the employer, who pockets the difference, re-moving the incentive for employees to choose alower priced plan. More efficient health plans or in-surers have little incentive to reduce prices if lowerprices do not help them gain market share. Andonce a person has insurance, the current systemmakes patients insensitive to price even for deci-sions such as where to undergo elective surgery, filla prescription, or obtain diagnostic tests. Copay-ments and deductibles can compensate only to theextent that the patient can make choices aboutwhich provider to use.

Even under the current system, the patient hasno choice when it comes to many types of deci-sions. Usually, once a patient chooses a doctor,health plan, or hospital, decisions such as whichlaboratory, imaging facility, or specialist to use arepredetermined. This is especially true in managedcare organizations and provider networks.

One choice all patients make is the frequency ofvisits for routine concerns. Copayments help makeprice a factor in these decisions. One of the resultsof the greater attention to health care costs in re-cent years has been increasing the use of copay-ments to reduce premiums and to discourage theoveruse of primary care visits.

Fragmented Customers Have Little Negotiating Power

Well-functioning competition is characterized bydemanding customers with enough clout to pushproviders to improve quality while at the same

time reducing costs. But when customers are frag-mented, as they are in health care, their power isgreatly diminished.

The United States has 1,500 different third-partypayers, such as insurance companies and HMOs,with roughly 200 serving a given region. Typically,3 to 12 payers – the number varies by region – repre-sent significant purchase volumes to a given hospi-tal, doctor, or other provider, while the rest of thepayers and individual patients have little bargain-ing power. Moreover, under the current system, pa-tients have little bargaining power with their insur-ance companies or other payers.

This fragmentation of patients and payers not on-ly limits competitive pressure but also drives uptransaction costs since many of the payers have dif-ferent policies, procedures, and forms for providerreimbursement. The long, customized forms, dif-ferent reporting requirements, and bureaucraciesdeveloped to handle the forms and requirementscontribute to high administrative costs, which ac-count for nearly 25% of health care expenditures.2

Providers, Patients, and Payers Lack Information

Health care customers also lack access to infor-mation that would improve decisions and in turnpressure providers to ameliorate medical outcomesand reduce costs. In most industries, customers cancompare product performance and price with com-peting products. Buyers of automobiles, for exam-ple, can go on test drives, compare prices at differ-ent dealers, draw on their own and friends’ pastexperiences, and consult publications that provideinformation on costs, margins, ratings of qualityand reliability, and used-car values.

Health care could hardly be more different. Pa-tients, payers, and referring physicians do not havereadily available measures of quality or of the re-lationship between price and quality for a givenphysician, procedure, course of treatment, or hospi-tal. Data from the Pennsylvania Health Care CostContainment Council reveal that both referringphysicians and patients continue to recommendand use the services of providers that have pooreroutcomes and higher costs than nearby rivals.3

Since many health care purchases are onetimeevents, patients cannot draw on past personal expe-riences. They usually receive only the expert opin-ion of one doctor (or sometimes two if the patientobtains a second opinion), and they frequently havedifficulty judging the quality of that advice.

Even under managed care, in which a gatekeeperphysician makes supposedly informed choices






about how a patient is treated, good informationabout the best type of care and provider for a givenpatient is lacking. Worse still, physicians must of-ten refer patients within a network of approvedproviders, which are selected by administrators.These administrators base their selection primarilyon price negotiations because they have little infor-mation about quality of care or outcomes. Withoutadequate quality measures and information, thedangers are that the network may either excludehigh-priced providers that deliver better qualitycare or include substandard providers in spite of thegood intentions of administrators and physicians.

This lack of relevant, comparative informationbased on meaningful medical outcome measures –not the complexity of medicine itself – prevents in-formed purchasing decisions. Customers in othercomplex, highly technical fields, such as aerospaceand computer software, require competitive bid-ding on products or services and delineate precisecriteria against which products are evaluated. Incontrast, the poor comparative information andlack of meaningful outcome measures in healthcare create incentives for hospitals and physiciansto compete based on what is observed: the hospi-tal’s pleasing physical environment, high-techequipment, or wide array of services; the physi-cian’s comforting bedside manner; even high prices.

Measures of customers’ satisfaction are inade-quate quality measures. The right information con-cerns short- and long-term outcomes of treatments

for particular diseases by specific providers, takinginto consideration the patient’s general health.Health care is not a monolithic service, but a myri-ad of types of services. Reformers must develop in-formation and outcome measures at the level ofspecific conditions and treatments instead of rely-ing on aggregate comparisons of provider networksor payment plans. Buying treatment for cancer willnever be like buying a car. But incentives in theU.S. health care system will dramatically improvewhen payers, patients, providers, and referring doc-tors can base decisions on comparisons of relevantoutcome measures and prices.

As health care moves increasingly toward pro-vider capitation (a fixed dollar amount per patientin the plan per period of time), the need for mean-ingful information is more crucial than ever. His-torically, the attitude of the U.S. health care systemwas, “If it might work, try it.” Today the equallyrisky bias is, “If we’re not sure, don’t do it.” Thiskind of thinking can only stifle innovation anderode quality. Better information is the antidote toeither bias, allowing decisions to be based on ex-pected outcomes.

Providers’ Incentives Increase CostsIn a well-functioning competitive market, pro-

ducers’ desires to raise prices or create more de-mand are counterbalanced by buyers who purchaseonly what they need and can afford. Demand riseswhen prices fall or when quality at a given price in-creases. These simple economic laws do not applyto health care providers in the United States be-cause the health care system skews their incentivesin a number of ways.

Hospitals and Outpatient Facilities: Incentivesto Maximize Reimbursement. Beginning in thepost-World War II period, hospitals were reim-bursed on a cost-plus basis, which in turn producedrapidly escalating hospital costs. The MedicareProspective Payment System, implemented in1983, granted hospitals a fixed fee based on the di-agnosis that resulted in the patient’s admission to

the hospital. (Changes in Medicarecarry particular significance becauseother players tend to follow Medi-care and implement the same rules.)This diagnosis-related group (DRG)reimbursement created incentives toreduce hospital stays and treatmentcosts. In the decade following its introduction, DRG reimbursementrules reduced the average length ofstay for an inpatient by half a

day, and the number of inpatient hospital staysdropped by 20%.

Corrections needed to be made to the cost-plussystem, which created incentives for providers toovertreat. But fixed-price reimbursement skews incentives in the opposite direction, pressuringproviders to undertreat and to discharge patientsprematurely. These incentives create the risk thatundertreatment or early discharge will raise overallcosts by increasing the rate of recurrent or pro-longed health problems. They also encourage hos-pitals to admit some patients unnecessarily andthen quickly discharge them.

Health care incentives willdramatically improve whencustomers can base decisions on relevant outcome measures.




PHOTO BY BRUCE T. MARTIN 135

Outpatient reimbursement has not yet changedto a DRG-like system. The cost-plus reimburse-ment combined with incentives for the earlier dis-charge of hospital patients has led hospitals andother providers to open many new outpatient facili-ties. Some of the resulting changes were produc-tive. Effective outpatient treatment and surgeriesare helping to reduce costs. However, there have also been unproductive results. For example,providers manipulated the DRG rules when theywere first implemented by delaying admission ofsome patients and instead administering expensivedrugs or treatments in the emergency room. Whilethis specific practice has been forbidden, incentivesfor the overtreatment of outpatients remain.

Physicians: Incentives to Increase Services.While the DRG rules encourage hospitals to under-treat, physicians currently have incentives to in-crease the volume of services they perform, even ifthose additional services do not lower costs or im-prove medical outcomes. Although physician capi-tation (a fixed dollar amount per primary care pa-tient per period of time) aims to correct incentives,it may lead to undertreatment because physiciansearn more by limiting care, including tests and re-ferrals. Salary is also becoming more common, andits incentives are volume neutral. But most physi-cians still face an incentive structure in which theyearn more by performing more tests or expensiveprocedures because they are paid for each serviceperformed. The recently implemented Resource-Based Relative Value System (RBRVS) does lowerreimbursement for technical procedures likesurgery relative to cognitive services like office vis-its. But lower pay per procedure actually creates in-centives for physicians to perform more proceduresin order to maintain their incomes.

We are not arguing that doctors unscrupulouslytake advantage of patients and payers. Medicalpractice is complex and requires professional judg-ment. Furthermore, many legitimate efforts to carefor the patient increase the use of medical services.Physicians cannot in good conscience do less for a patient or pursue less costly treatments withoutevidence that these decisions improve outcomes orquality of life.

But the complexity of medicine cannot explainwhy demand for physicians’ services is higher in ar-eas where there are more physicians. Doctors withthe time and facilities can increase demand by per-forming more tests and procedures, seeing patientsmore frequently, or operating on less severely ill pa-tients. For example, the rate of open heart surgeryon residents of Manchester, New Hampshire, dou-bled the year a local hospital opened an open-heart-






surgery service.4 Before the local service opened,90% of bypass operations on patients from the com-munity involved three or more arteries. Three yearsafter the local center opened, over 50% of the by-passes involved only one or two arteries. But an ap-preciable improvement in coronary-heart-diseasemortality did not accompany this surgical treat-ment of less severe coronary disease, and it is notclear whether other measures of health outcomeswere improved. Cardiologists can debate the med-ical merits of operating on patients with less severecoronary disease. We simply use this example to il-

lustrate the point that doctors can increase demandfor medical services without clear evidence of im-proving outcomes.

This tendency for supply to create demand is partof the reason that the United States has a generalshortage of primary care physicians compared withthe number of specialists. In a competitive system,the income potential for specialists, now higherthan that of primary care physicians, would fallwith oversupply. But since the availability of spe-cialists generates demand for specialized care, theoversupply perpetuates itself. The increasing debtburden of medical school graduates, which leadsthem to high-paying specialties, only serves to ac-centuate this tendency.

Physicians: Incentives to Make Expensive Refer-rals. In addition to providing care, physicians alsoact as purchasing agents on behalf of their patientsby ordering tests or making referrals. Referringphysicians have traditionally had no incentive tochoose a less expensive lab, ancillary service, orother provider since patients’ insurance paid thebills. Instead, convenience, established relation-ships, perceived quality, or direct financial rewardsfrom equity interests in labs or facilities have deter-mined referral patterns for independent physicians.

The incentive to perform more tests and proce-dures is strongest when the physician has a finan-cial interest in the facility or equipment. For exam-ple, a Florida State University study found thatphysician-owned laboratories in Florida performedtwice as many tests per patient as independent labs.

Similarly, a University of Arizona study showedthat physicians with diagnostic imaging equipmentin their offices ordered four times as many imag-ing exams as physicians who referred patients forimaging tests.

Congress passed the Stark bill, which became ef-fective in 1992, forbidding physicians from billingMedicare patients for services performed in clinicallabs in which the doctor has an equity interest. Andother legislation has passed or is pending to limitself-referral further. But the more fundamental un-derlying problem, physicians’ incentives, remains

unaddressed. If physician-ownedlabs are more efficient, then pro-hibiting their existence would be amistake. Ideally, physicians shouldhave incentives to promote and im-prove health rather than to increasethe use of health care services.

Physicians: Incentives to IncreaseFees. As health care technologiesevolved in the United States, highprices were placed on novel proce-

dures, such as gastrointestinal endoscopy, becausethese procedures carried higher risk and were of-fered by relatively few, highly skilled physicians. Ina competitive market, the diffusion of technologyand increase in the supply of such services woulddrive down their prices over time. In health care,however, the fees did not decline because patientswere not price sensitive and insurance payments tophysicians were based on customary charges ratherthan on costs.

In most industries, market forces determine howmuch a company can charge; prices need to be highenough to cover costs but low enough to attractcustomers. Companies can charge higher prices on-ly for products or services that are differentiated,that is, products and services that provide morebenefit to the customer. In health care, however,the normal rules do not apply. High prices havetheir roots in the “usual, customary, and reasonablecharges” on which insurance companies tradition-ally based their payments to physicians. This struc-ture made sense in the infancy of the health insur-ance industry in the United States, when mostpatients did not have insurance, paid for their ownhealth care, and were price sensitive. At that time,doctors faced powerful constraints in setting theircustomary charges.

As health insurance became more widespread,payers retained the “usual, customary, and reason-able” structure, even though a competitive marketceased to exist in physician services. With insur-ance the norm, doctors no longer attracted patients

Physicians should haveincentives to improve healthrather than to increase the use of health care services.





by setting lower prices. Indeed, patients with insur-ance came to view low prices as a signal of lowerquality. Since any fee could become “usual, cus-tomary, and reasonable” as long as enough doctorscharged it, physicians were able to boost their in-comes by regularly increasing their fees so that fu-ture reimbursement calculations would be basedon higher charges.

Over the past decade, changes in physician reim-bursement have limited the ability of physicians toincrease fees. But piecemeal regulations can be cir-cumvented. For example, when Medicare imple-mented a fee freeze in 1984 that lasted for twoyears, physician group practices responded by set-ting artificially high rates for new physicians in thegroup. Similarly, some payers have imposed fixed-fee structures on physicians, but physicians havecircumvented them with so-called balance billing:physicians simply bill patients for the differencebetween their “list charges” and the approved“fixed fee.” This strategy reduces the payers’ pricesensitivity and their incentive to work for price re-ductions since they are no longer responsible forthe entire bill. While balance billing may make pa-tients more price sensitive, they often do not knowin advance whether the bill will be significant. Andwhen the balance is small, patients are often in-clined to pay. Fortunately, an increasing number ofinsurance contracts now restricts doctors from bal-ance billing patients.

Physicians: Incentives to Practice DefensiveMedicine. The threat of malpractice or the insis-tence of patients pushes even doctors paid by salaryor capitation to practice defensive medicine by or-

dering more tests and procedures than are oftennecessary. The most widely cited study estimatesthe direct cost of defensive medicine to be about1% of total health care expenditures.5 But suchmeasures understate the problem because thethreat of malpractice may also indirectly affectcosts by coloring physicians’ judgments. Still, thepopular notion that the threat of malpractice is thecrux of the health care problem is oversimplified.Legal reform is essential to address the malpractice

problem and help retain good physicians in fieldssuch as obstetrics. However, malpractice reformalone will not produce the dramatic changes thatU.S. health care needs.

Providers’ Incentives Encourage Overinvestment

The U.S. health care system still supplies incen-tives for excessive capital investment by providers.Companies in a competitive market invest to en-hance differentiation or to lower costs. Becausethey bear the costs and risks of investment, they in-vest only when they anticipate a reasonable return.Those that make inappropriate investments facedeclining profits and eventually go out of business.

This has not been the case for capital expendi-tures in the U.S. health care industry. Until 1992,reimbursement by Medicare for capital invest-ments was cost-plus. Thus, providers profited bybuilding facilities and adding new equipment with-out the usual market constraint of needing to besure that the capital investments would pay off.Regulators became aware of the resulting incentiveto overinvest and tried to handle it by creating re-view boards to determine community needs. Theydid not attempt to correct the incentive itself.

What’s more, the excess capacity of beds orequipment, such as imaging machines or medicalhelicopters, did not produce lower prices. Healthcare defied the usual laws of gravity for three rea-sons. First, reimbursement was not dependent onhow fully a facility was used. Second, providerswere protected from failure not only by cost-plus

reimbursement but also by commu-nity interests in maintaining localhealth care facilities. Third, once fa-cilities existed, there was a strongtendency to create demand to fillthem. Ultimately, hospitals and out-patient treatment centers had incen-tives to overinvest in equipment andfacilities because these investmentsattracted both doctors and patients.Without real measures of outcomes,

state-of-the-art facilities became the focus of healthcare competition.

In 1992, the Medicare capital reimbursementrules changed, limiting the rate at which major cap-ital investments could be amortized. This change,coupled with increasing national attention tohealth care costs, substantially enhances incen-tives for improving the productivity of capitalequipment. Cost-saving innovations in investmentproductivity will begin to emerge after a time lag.

Companies in a competitivemarket invest only when theyanticipate a reasonable return –not so in health care.






But the benefits of this change are unnecessarily di-luted by too many loopholes allowed in the newMedicare rules. These rules include significant ad-justments, such as those for geographic location (regional, as well as urban versus rural), patient population (severity of illness, or “case-mix”), andreimbursement features (percentage of uninsuredor indigent patients). Together, the adjustmentsmake the system still effectively cost-plus.

Exit Barriers Protect Substandard Payers and Providers

Incentives for cost reduction will be fully effec-tive only if lower quality, inefficient providers andinsurance companies are allowed to fail. Anyhealthy competitive market forces the exit of sub-standard players, which are displaced by efficientones. The net result is lower costs without compro-mising quality.

The past two decades have witnessed dramaticreductions in the demand for hospital facilities, butrelatively little capacity has been eliminated. Thecost and quality penalty to the nation of too manyfacilities is high. Low volumes drive up costs, asfixed overhead must be spread over few patients. At the same time, quality suffers. For example,providers that perform fewer than 150 open heartprocedures per year have higher death and compli-cation rates. As a result, the American College ofSurgeons has recommended that each cardiacsurgery team perform at least 150 operations peryear. Other studies show that hospitals that per-form a higher volume of a given procedure havelower mortality rates and shorter inpatient stays.6

It is not beneficial to have reimbursement rulesthat guarantee any provider the ability to offer anyservice even if their quality and utilization rates arelow. But in U.S. health care, there has been a sur-prising reluctance to force substandard providers toexit either by closing entire facilities or by droppingspecific services.

The idea that the closure of some hospitals andsome services within hospitals would be good pub-lic policy is radical given the history of providingpublic incentives to open hospitals in every U.S.community. The U.S. hospital system developed ata time when the full range of medical care could bereasonably provided at a community hospital.Communities still benefit today from the readyavailability of services like routine emergency care,routine obstetric care, and care for common disor-ders requiring hospitalization. However, for com-plex care such as high-risk obstetrics, trauma care,and organ transplantation, regionalization and ra-

tionalization could significantly enhance bothquality and efficiency.

While traveling to a preeminent regional facilitymay sound expensive and inconvenient, the sav-ings in costs and the promise of better short- andlong-term medical results can easily make it worth-while for both patients and payers. Higher volumesof specialized treatments lead to better outcomesand lower costs, not only because physicians be-come more skilled with more practice but also be-cause whole teams of medical professionals learneffective routines and develop expertise in proto-cols and problem spotting. As a result, facilitiesthat have high volume in a specialized service alsotend to have lower costs in that service.

The current trends of consolidation into providernetworks, however, could have detrimental effectson the cost and quality of specialized services. Amanaged care network is fine for primary care andrelatively simple specialized care. However, therisks are that either high-quality providers will beexcluded because they cannot conclusively provecost-effectiveness or substandard providers of com-plex and highly specialized care will be hidden andprotected within the networks. Although managerswill not intentionally maintain clearly substandardservices, measuring outcomes is difficult, and net-works will be reluctant to lose their full-service sta-tus based on uncertain evidence of substandardcare. The guaranteed patient flow to in-networkproviders, then, creates new exit barriers.

Public policy should play a critical role in foster-ing competition. Although some consolidation isdesirable to reduce excess capacity, it is importantnot to relax antitrust rules to the point of under-mining competition. Excessive consolidation willrisk creating very powerful providers with less needto respond to their customers. It will also limit theexperimentation that is critical to stimulating newprocedures and treatments.

Piecemeal Solutions Treat Only the Symptoms

The skewed incentives of the U.S. health caresystem are not the result of inattention. A greatdeal of regulatory effort has focused on fixing theproblems. Unfortunately, much of this effort hasaimed at treating symptoms rather than the under-lying causes. In fact, new regulations make the sys-tem less efficient, while failing to improve quality.

For example, when DRG reimbursement short-ened hospital stays by encouraging earlier dis-charge, concerns surfaced that hospitals’ efforts toreduce costs might diminish the quality of care. So





the government added new regulations and expand-ed the bureaucracy to address the issues of qualityand utilization. Hospitals responded to these quali-ty regulations by creating parallel utilization re-view staffs. The net result was health care reduc-tion, not cost reduction. Money previously spenton patient care was shifted to administration.

Another result of such piecemeal solutions hasbeen a complex collection of sometimes incon-sistent rules that provide rewards to those who can figure out how to manipulate the system. Bill-ing consultants have taught doctors and hospitaladministrators to maximize reimbursement. Forexample, when fixed fees were established for a given procedure, doctors learned the practice of unbundling: billing separately for the componentparts of a procedure to increase fees. The rise offixed-fee third-party payers and the increasing bur-den of the uninsured encouraged cost shifting –those patients with less restrictive payment plansabsorbed the costs of caring for others. Onlychanges in incentives can close these loopholes.Additional layers of regulation will be circumvent-ed and will create new administrative cost burdens.

The failure to look at the health care systemcomprehensively and to focus on the long term hasalso raised systemwide costs. For example, manyU.S. mothers receive little prenatal care, but thecost of universal prenatal care is almost negligiblecompared with the cost of intensive care for prema-

ture babies and the cost of long-term care for chil-dren with considerable health problems as a resultof poor prenatal care. As improved outcome mea-sures are developed, it is important to determinewhen apparently expensive care at one stage in anillness actually reduces overall costs or improvesoutcomes at subsequent stages.

In addition, seemingly unrelated governmentpolicies contribute to rising health care costs. Themost obvious example is the subsidization of tobac-co. Given the demonstrated health risks of tobacco,the subsidies drive up health care costs. The Clin-ton administration’s suggested tax increase on to-bacco products does strengthen incentives for

healthful behavior by making smoking expensive.But subsidizing tobacco and then taxing it is yet another example of complicated, piecemeal regu-lation that could be simplified if we looked at thesystemwide costs and benefits of specific policies.

Recent Progress on Cost Reduction IsNot Enough

In response to national attention to rising costsand the DRG reimbursement system, a number ofcost-reducing advances began to emerge by the late1980s. Indeed, the results of the new, albeit incom-plete, incentives for cost reduction have becomenoticeable at the national level. Although the med-ical component of the consumer price index is stillrising faster than inflation, the rate of increase hasdropped enough to shave $15 billion off expectedU.S. health care expenditures in a single year.

Specific examples of cost-reducing innovationsspan a wide range of treatments and procedures.Consider the antibiotic ceftriaxone. Until the mid-1980s, advances in antibiotic development tendedto deliver broader spectrum antibiotics. The 1988introduction of ceftriaxone offered a drug with es-sentially the same spectrum as existing drugs of thesame class, but at a lower cost due to the need foronly one intravenous dose every 24 hours instead ofevery 3 or 4. Less frequent dosing means less nurs-ing time and lower aggregate treatment costs,

while providing equally good results;it also allows some patients to be discharged from the hospital and re-ceive the injection on a daily outpa-tient basis. Because of these pharma-coeconomic advantages, ceftriaxonequickly became the top selling phar-maceutical product in hospitals. Oth-er examples include new therapiesand surgical techniques. Laparosco-py reduces the cost and recovery time

from procedures such as cholecystectomies and appendectomies. Gene therapy is creating the po-tential for dramatic cost reduction by restoring normal function in congenital diseases like cysticfibrosis and ADA deficiency. Most pharmaceuticaland biopharmaceutical companies are now con-sciously analyzing both the clinical and the eco-nomic advances of potential new products to decidewhich products to pursue and which research-and-development investments to make.

There are still other indications of the power ofimproved incentives to restore health to the U.S.health care system. Numerous private-sector ini-tiatives have begun to ratchet down the rate of

Some consolidation is desirable.Too much will risk creatingpowerful providers with littleneed to respond to customers.






health care growth. Large employers are beginningto ask employees to pay more when choosing moreexpensive health care plans. Small-business coali-tions are demanding and receiving greater valuefrom insurers and providers. Employers are ferret-ing out information to empower their health bene-fit choices, and providers and insurers are learningto respond more effectively to informed buyers.

These are positive signs, but they are not enough.The current trends should not be used as an excuseto avoid the real reform of incentives. Indeed, theanticipation of reform is itself driving cost reduc-tion. And if weak and uncoordinated incentives canencourage such innovation, a systematic introduc-tion of clear, competitive market incentives shouldbe able to achieve dramatic results. Innovation inresponse to competitive forces will bring healthcare costs under control without rationing care orretarding the search for cures for currently untreat-able diseases.

Reform Can Cure Competition inHealth Care

Competition in U.S. health care has produced abreathtaking rate of advance in state-of-the-arttreatments for a wide range of diseases and injuries.People come from all over the world for treatmentby U.S. doctors in U.S. hospitals with U.S.-devel-oped technologies. Reform should preserve this ex-cellence and expand the scope of innovation. A last-ing cure for U.S. health care should incorporate fourbasic elements: corrected incentives to spur pro-ductive competition, universal insurance to secureeconomic efficiency, relevant information to en-sure meaningful choice, and vigorous innovation toguarantee dynamic improvement.

Incentives for Productive Competition. Much ofthe health care debate is based on the premise thatbecause competition has failed to control costs inthe past, it will not be able to do so in the future.Paradoxically, competition, usually a powerfulforce for both quality enhancement and cost reduc-tion, appears to be driving health care costs throughthe ceiling. But the problem, as we have seen, lies inthe skewed incentives that allow providers, payers,and suppliers of drugs and equipment to prosperwhile costs escalate.

“Managed competition” has been offered up as asolution. It encourages patients and employers tojoin large purchasing cooperatives, which will con-tract for health plans with large payers and organizeproviders and physicians into integrated deliverynetworks. But the pooling of customers and pro-viders could create bilateral monopolies with lit-

tle incentive to innovate. More powerful payerscould slow innovation by refusing to pay for newtreatments in the effort to contain costs. Moreequal groups of customers and payers, without re-structured incentives, could increase the moun-tains of paperwork generated by battles over whoshould pay the bills. Indeed, without restructuredincentives, managed competition will only in-crease the power of the parties engaged in dysfunc-tional competition.

Reform must eliminate the incentives that createdysfunctional competition. Rather than managedcompetition, reform must foster rigorous competi-tion among providers and among payers to delivervalue to customers. Providers and their suppliersshould earn higher profits only when they makecost-effective advances in medical outcomes.

Four conditions will help foster productive com-petition in health care:� Avoid overconsolidation. Providers must beforced to compete with one another on the basis ofquality and price for specific services. � Maintain antitrust laws in order to ensurehealthy rivalry. � Allow exit of substandard providers when region-al competition is not restricted. The opportunity toprosper must be coupled with the risk of failure. Inaddition, a safety net must be set up to protect sub-scribers if their insurance plan fails. � Reject price caps because they will have devastat-ing effects on innovation in new drugs and devices.Instead, competition among established productsshould be encouraged to push down their prices.

Payers’ and patients’ incentives must also bealigned. Payers should profit when they negotiategood value for their subscribers. Patients shouldbenefit when they seek good values. It is notenough to pool patients into purchasing groups orcreate streamlined provider networks. Unless in-centives are changed, payers will continue in theirattempts to shift costs rather than identify goodvalues, and providers will continue to manipulatethe reimbursement rules without necessarily im-proving quality.

Four steps will help align patients’ and payers’ in-centives and avoid the fruitless cost shifting thattakes place today: � Align interests. Payers must have the legal re-sponsibility for paying their subscribers’ bills. � Simplify the content of health insurance to re-duce disputes over claims. � Outlaw balance billing. � Increase patient responsibility. Patients shouldbear some portion of costs through a noticeable co-payment up to an income-graduated cap.





Insurance Coverage for Economic Efficiency.Universal coverage is essential for economic effi-ciency as well as for equity. Many of the skewed in-centives and inefficiencies stem from problems cre-ated by uncompensated care.

The best way to eliminate costly practices likecost shifting and patient dumping is not by creatingmore reviews, audits, or penalties. Reform shouldmake everyone a paying customer. The cost of universal coverage will not be as high as some fearbecause the expense of the uninsured is already largely borne by the health care system through un-compensated care assessments that providers re-coup by raising average prices. Moreover, the costsnow borne to serve the uninsured will be reducedbecause patients who lack access to primary carecurrently use expensive emergency-room care as asubstitute.

Universal coverage is also important to ensurethat competition will work in the interests of allpatients. Otherwise, many providers that currentlyserve the poor will be forced to exit. The solution isto make the poor into paying customers who decidewhich providers will best serve them.

Information for Meaningful Choice. Effectivecompetition requires free choice, but choice with-out good information is useless. Competition willwork only when decisions by providers, referringdoctors, payers, and patients are based on relevant,comparable information about price and medicaloutcomes. That information must be at the level ofspecific treatments by specific providers and mustinclude long-term outcomes and immediate re-sults. There has been much discussion about pro-viding consumers with information about insur-ance plans to help them in their purchasingdecisions. It is far more critical to provide all partieswith specific information about treatment out-comes and prices.

Without this kind of information, reform riskssacrificing quality to the goals of access and costcontainment. Hospitals may discharge patients be-fore they are ready for outpatient care, and physi-cians may skimp when ordering tests or making re-ferrals. Medical outcome information also guardsagainst the perils of overconsolidation. Substan-dard providers should not be protected fromhealthy competition because customers are captivewithin consolidated health networks.

The development of germane and accessible out-come measures should be one of the nation’s high-est research priorities. Admittedly, this will be noeasy task. But rapid progress is already being made,and nothing will speed the development of bettermeasures faster than the widespread dissemination

of the data and measures already in use. With goodinformation available to all parties, informedchoice – not restricted choice – will promote pro-ductive competition that raises quality and drivesdown costs.

Innovation for Dynamic Improvement. The na-tional debate defines technology as the enemy andfocuses on how to cut fat and eliminate waste in thecurrent system with reforms like health plan buy-ing alliances, consolidated networks, and price capson drugs and devices. But these reforms are essen-tially ways to deliver today’s health care more effi-ciently and will not reduce costs enough. In fact,overconsolidation of networks and price restraintson or biases against new drugs and devices will un-dermine incentives for innovation. A real solutionto our health care cost problem requires a dynamicview, one that fosters the kind of innovation thatpushes down costs and enhances quality.

Pharmaceutical, biotechnological, and medicaldevice companies are beginning to deliver cost-re-ducing innovations. Private companies are begin-ning to develop quality comparisons and outcomemeasures. Small businesses are beginning to formbuying groups to negotiate with payers for qualitycare at competitive prices. As a result, the rate ofhealth care cost increases is slowing.

Health care reform must build on this progress bycreating still stronger incentives for both medicaland managerial innovation. Reformers must notconfuse onetime efficiencies with sustained costimprovement. Innovation, the missing principle inall the contending reform proposals, is the onlytrue, long-term solution for high-quality, affordablehealth care.

Notes1. See, for example, J. Showstack, et al., “Association of Volume withOutcome of Coronary Artery Bypass Graft Surgery,” Journal of the AmericanMedical Association, vol. 257 (1987), pp. 785-89; Charles Marwick, “Us-ing High-Quality Providers to Cope with Today’s Rising Health CareCosts,” JAMA, vol. 268 (1992), pp. 2142-45; and James W. Winkelman, etal., “Cost Savings in a Hospital Clinical Laboratory with a Pay-for-Perfor-mance Incentive Program for Supervisors,” Archives of Pathology andLaboratory Medicine, vol. 115 (1991), pp. 38-41.

2. Steffie Woolhandler and David U. Himmelstein, “The DeterioratingAdministrative Efficiency of the U.S. Health Care System,” New En-gland Journal of Medicine, vol. 324, no. 18 (1991), pp. 1253-58.

3. See David Wessel and Walt Bogdanich, “Closed Market: Laws of Eco-nomics Often Don’t Apply in Health-Care Field,” Wall Street Journal,January 22, 1992, p. A1.

4. Philip Caper, “Database Strategies for the Management of Clinical De-cision Making,” New Perspectives in Health Care Economics (London:Mediq Ltd., 1991), p. 65.

5. Roger A. Reynolds, John A. Rizzo, and Martin L. Gonzalez, “The Costof Medical Professional Liability,” JAMA, vol. 257 (1987), pp. 2776-81.

6. See V.E. Stone, et al., “The Relation Between Hospital Experience andMortality Rates for Patients with AIDS,” JAMA, vol. 268 (1992), pp. 2655-61; and H.S. Luft, et al., “Should Operations Be Regionalized?” New England Journal of Medicine, vol. 301 (1979), pp. 1364-69.

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A R T I C L E

Will Disruptive Innovations Cure Health Care?

by Clayton M. Christensen, Richard Bohmer, and

John Kenagy

Included with this full-text


article:

The Idea in Brief—the core idea

The Idea in Practice—putting the idea to work

1

Article Summary

3


A list of related materials, with annotations to guide further

exploration of the article’s ideas and applications

13

Further Reading

Product 6972


page 1

The Idea in Brief The Idea in Practice

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The U.S. health care industry is ailing. The symptoms? Expensive, inconvenient deliv-ery systems that leave more and more con-sumers dissatisfied. Why? Major health care institutions have “overshot” the level of care most patients need. Researchers and practi-tioners focus on the most complicated dis-eases, while paying insufficient attention to the needs of patients with more common ailments.

The cure? All health care industry players must embrace disruptive innovations: cheaper, simpler, more convenient prod-ucts or services that ultimately let less ex-pensive professionals provide sophisti-cated service in affordable settings. Consider angioplasty, used by cardiologists with patients who not long ago would have needed invasive, costly surgery by open-heart specialists. Or the latest blood glucose meters, which allow diabetic pa-tients to monitor their own health—accu-rately, conveniently, and inexpensively.

We need many more of these disruptive in-novations to revitalize the health care in-dustry. Companies that develop them will grow profitably with less investment. Hos-pitals and managed-care institutions will stem their financial hemorrhaging. When industry players and consumers join forces to promote affordable, high-quality medi-cal services, everyone will win.

Disruptive innovations in other industries offer lessons for transforming health care:

Create a system that matches clinicians’ skill levels to the level of medical difficulty.

Use technology to channel simple problems (e.g., strep throat) to clinicians who can follow predictable rules for diagnosis and treatment. For example, expand nurse practitioners’ role as primary care providers and provide tools that allow them to accurately refer more com-plicated conditions to physicians with more sophisticated diagnostic abilities.

Invest more money in technologies that simplify complex problems, and less in high-end technologies.Today most R&D dollars go to complex solu-tions for complex problems. But more venture capital must flow to projects focused on tech-nologies that simplify diagnosis and treat-ment—especially of common diseases. By launching a series of such disruptive business ventures, major health care companies (Johnson & Johnson, Baxter, Merck) could spur significant growth—with less investment.

Don’t be afraid to invent the institution that could put you out of business.

We’ll always need some general hospitals for critical care (just as we still need mainframe computers after PCs transformed that indus-try). But most health care needs can be better met through specialized institutions that pro-vide state-of-the-art care for a single category of disorders, such as cardiac or renal illnesses.

Overcome the inertia of regulation.

Instead of working to preserve the existing system at all costs, regulators should be ask-ing, “How can we enable disruptive innova-tions to emerge?”

Example:An entrepreneur creates a portable X-ray machine for use in medical offices rather than in hospitals—promising significant

cost savings. Regulators could support the new technology and address any concerns about possible risks. How? Require that all images interpreted by nonradiologists be transmitted via Internet to a second-opinion center. There, skilled radiologists could check or confirm initial diagnoses.


by Clayton M. Christensen, Richard Bohmer, and

John Kenagy

harvard business review • september–october 2000 page 3

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Health care may be the most entrenched, change-averse industry in the

United States. The innovations that will eventually turn it around are

ready, in some cases—but they can’t find backers.

Imagine a portable, low-intensity X-ray ma-chine that can be wheeled between offices on asmall cart. It creates images of such clarity thatpediatricians, internists, and nurses can detectcracks in bones or lumps in tissue in their of-fices, not in a hospital. It works through a pat-ented “nanocrystal” process, which uses night-vision technology borrowed from the military.At 10% of the cost of a conventional X-ray ma-chine, it could save patients, their employers,and insurance companies hundreds of thou-sands of dollars every year. Great innovation,right? Guess again. When the entrepreneurwho developed the machine tried to license thetechnology to established health care compa-nies, he couldn’t even get his foot in the door.Large-scale X-ray equipment suppliers wantedno part of it. Why? Because it threatened theirbusiness models.

What happened to the X-ray entrepreneur isall too common in the health care industry.Powerful institutional forces fight simpler alter-natives to expensive care because those alterna-tives threaten their livelihoods. And those oppo-

nents to low-cost change are usually lined upthree or four deep. Imagine for a moment thatour entrepreneur was able to license the tech-nology. Even then, he would probably face insu-perable barriers. Regulators, afraid of puttingpatients at risk, would withhold approvals. Radi-ologists, who establish the licensing standardsthat regulators enforce, don’t want to lose theirjobs, so they’d fight it, too. Insurance compa-nies, which approve only established licensedprocedures, would refuse to reimburse for it.And hospitals, with their large investments inradiology and emergency departments, want in-juries to flow to them—so they, too, would jointhe forces holding back change.

This resistance to low-cost alternatives is un-derstandable, but it’s not in the best interestsof the industry or of the patients it serves.Quite the reverse—the health care industrydesperately needs to open its doors to marketforces. Health care professionals often shud-der when they hear that phrase “marketforces.” But when we use it, we’re not talkingabout letting insurance companies microman-


page 4 harvard business review • september–october 2000

age doctors as they practice medicine or aboutputting profits above patient care. Rather,we’re talking about being open to disruptivetechnologies and business models that maythreaten the status quo but will ultimatelyraise the quality of health care for everyone.

Make no mistake: the U.S. health care in-dustry is in crisis. Prestigious teaching hospi-tals lose millions of dollars every year. Healthcare delivery is convoluted, expensive, andoften deeply dissatisfying to consumers. Man-aged care, which evolved to address some ofthese problems, seems increasingly to contrib-ute to them—and some of the best managed-care agencies are on the brink of insolvency.We believe that a whole host of disruptive in-novations, small and large, could end the cri-sis—but only if the entrenched powers get outof the way and let market forces play out. Ifthe natural process of disruption is allowed toproceed, we’ll be able to build a new systemthat’s characterized by lower costs, higherquality, and greater convenience than couldever be achieved under the old system.

What’s Wrong with Health Care

In any industry, a disruptive innovation sneaksin from below. While the dominant players arefocused on improving their products or ser-vices to the point where the average consumerdoesn’t even know what she’s using (thinkoverengineered computers), they miss sim-pler, more convenient, and less costly offer-ings initially designed to appeal to the low endof the market. Over time, the simpler offeringsget better—so much better that they meet theneeds of the vast majority of users. We’ve seenthis happen recently in the telecommunica-tions industry, where routers—initially dis-missed by leading makers of the faster, morereliable circuit switches—came to take overthe market.

The graph “The Progress of Disruptive Inno-vation” illustrates this dynamic. The top solidline depicts the pace of technological innova-tion—the improvement an industry creates asit introduces new and more-advanced productsto serve the more-sophisticated customers atthe high end of the market. We call these sus-taining innovations. The shaded area outlinesthe rate of improvement consumers can absorbover the same time. The pace of sustaining in-novation nearly always outstrips the ability ofcustomers to absorb it. That creates the poten-

tial for upstart companies to introduce disrup-tive innovations—cheaper, simpler, more con-venient products or services that start bymeeting the needs of less-demanding custom-ers. The progress of these disruptive innova-tions is shown by the bottom solid line. Disrup-tive technologies have caused many ofhistory’s best companies to plunge into crisisand ultimately fail.

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This phenomenon of overshooting the needsof average customers and creating the poten-tial for disruption quite accurately describesthe health care industry. If we were to draw agraph to illustrate health care specifically, wewould measure the complexity of diagnosingand treating various disorders on the verticalaxis. The least-demanding tiers of the marketare patients with disorders such as simple in-fectious diseases. The most-demanding tiers in-clude patients with complex, interactive prob-lems such as an elderly man with a broken hipcomplicated by poor health from long-stand-ing diabetes, hypertension, and heart dis-ease—situations in which multiple systems ofthe body are involved, and cause and effect aredifficult to disentangle.

Our major health care institutions—medicalschools, groups of specialist physicians, generalhospitals, research organizations—have to-gether overshot the level of care actuallyneeded or used by the vast majority of pa-tients. Indeed, most players in today’s healthcare system are in a lockstep march toward themost scientifically demanding challenges. Be-tween 1960 and now, for example, our medicalschools and residency programs have churnedout specialists and subspecialists with extraor-dinary capabilities. But most of the things thatafflict us are relatively straightforward disor-ders whose diagnoses and treatments tap but asmall fraction of what our medical schoolshave prepared physicians to do. Similarly, thevast majority of research funding from the Na-tional Institutes of Health is aimed at learningto cure diseases that historically have been in-curable. Much less is being spent on learninghow to provide the health care that most of usneed most of the time in a way that is simpler,more convenient, and less costly.

General hospitals—especially teaching hos-pitals—have likewise overshot the needs ofmost patients. Their impressive technologicalability to deliver care enables them to addressthe needs of a relatively small population of

Clayton M. Christensen

is a professorof business administration at HarvardBusiness School in Boston. RichardBohmer is a physician and also a se-nior lecturer at Harvard BusinessSchool. John Kenagy is a physician, avisiting scholar at Harvard BusinessSchool, and a clinical associate profes-sor of surgery at the University of Wash-ington in Seattle.



very sick patients. But in the process of addingand incurring the costs of such capabilities, theyhave come to overserve the needs of the muchlarger population of patients with less seriousdisorders. Most types of patients that occupiedhospital beds 20 years ago are not there today;they’re being treated in lower cost, more-focused settings. As the stand-alone cardiac carecenters, outpatient surgery centers, and otherfocused institutions get better and better, theybecome the price setters. As a consequence, theold high-cost institutions can’t compete finan-cially; nor are there enough really sick people tosustain them. Last year not a single teachinghospital in Massachusetts made money.

As a group, the medical schools, specialistphysicians, hospitals, and equipment suppliershave done an exceptional job of learning totreat and resolve difficult, intractable problemsat the high end. We stand in awe of what theyhave accomplished. But precisely because oftheir achievements, health care is now ripe fordisruption.

How Disruptive Innovations Work

To get a sense of what those disruptions mightbe, let’s look briefly at what has happened inother industries. Many of the most powerfulinnovations that disrupted other industriesdid so by enabling a larger population of less-skilled people to do in a more convenient, lessexpensive setting things that historically couldbe performed only by expensive specialists incentralized, inconvenient locations.

For example, in the 1960s when peopleneeded computing help, they had to take theirpunched cards to the corporate mainframecomputer center and wait in line for the data-processing specialists to run the job for them.Minicomputers and then personal computerswere disruptive technologies to the mainframemakers. At the outset, they weren’t nearly as ca-pable as mainframes, and as a consequence theprofessionals who operated the sophisticatedcomputers, and the companies that suppliedthem, discounted their value. But minicomput-ers enabled engineers to solve problems forthemselves that had required centralized com-puting facilities. And personal computers en-abled the unwashed masses—less-skilled peoplelike the rest of us—to compute in the conve-nience of their offices and homes.

Nearly every disruptive innovation in his-tory has had the same impact. George East-man’s camera made amateur photographywidespread. Bell’s telephone let people com-municate without the need for professionaltelegraph operators. Photocopying enabled of-fice workers to do things that historically onlyprofessional printers could do. Online broker-ages have made investing so inexpensive andconvenient that even college students now ac-tively manage their own portfolios. Indeed,disruptive technologies have been one of thefundamental mechanisms through which thequality of our lives has improved. In each ofthese cases, the disruption left consumers farbetter off than they had been—we don’t yearn

The Progress of Disruptive Innovation

Dominant players in most markets focus on sustaining innovations—on improving their products and services to meet the needs of the profitable high-end customers. Soon, those improvements overshoot the needs of the vast majority of customers. That makes a market ripe for upstart com-panies seeking to introduce disruptive in-novations—cheaper, simpler, more conve-nient products or services aimed at the lower end of the market. Over time, those products improve to meet the needs of most of the market, a phenomenon that has caused many of history’s best companies to plunge into crisis.

New perform

ance trajectory

of disru

ptive technologies

Perform

ance trajectory of

present technology (d

riven

by susta

ining innovatio

ns)

Time

Most-demanding customers

Least-demanding customers

Performance

Performance that customers in the mainstream market can absorb



to return to the days of the corporate main-frame center, for example.

Our health care system needs to be trans-formed in the same way. Rather than ask com-plex, high-cost institutions and expensive, spe-cialized professionals to move down-market,we need to look at the problem in a very differ-ent way. Managers and technologies need tofocus instead on enabling less expensive pro-fessionals to do progressively more sophisti-cated things in less expensive settings.

We need diagnostic and therapeutic ad-vances that allow nurse practitioners to treatdiseases that used to require a physician’s care,for example, or primary care physicians totreat conditions that used to require specialists.Similarly, we need innovations that enable pro-cedures to be done in less expensive, more con-venient settings—for doctors to provide ser-vices in their offices that used to be doneduring a hospital stay, for example. The graphs“Disruptions of Health Care Professions” and“Disruptions of Health Care Institutions” sug-gest the patterns by which these disruptive in-novations might transform health care.

Some innovations of exactly this sort havetransformed pockets of the health care system,and where they have happened, higher quality,greater convenience, and lower cost actuallyhave been achieved. Before 1980, for example,patients with diabetes could only knowwhether they had abnormal levels of glucose intheir blood indirectly; they used an often inac-curate urine test or visited a doctor who drew ablood sample and then measured its glucose

content on an expensive piece of laboratoryequipment. Today, patients pack miniatureblood glucose meters with them wherever theygo; they themselves now manage most aspectsof a disease that previously had required muchmore professional involvement. They get farhigher quality care far more conveniently. Nopatient or professional pines for the good olddays—even though the companies that madethe large laboratory blood-glucose testers wereall driven from the market, and endocrinolo-gists now face significantly reduced demandfor their services.

Angioplasty is another example. Before theearly 1980s, patients with coronary artery dis-ease were treated through bypass surgery. It re-quired a complex, technologically sophisti-cated surgical team, as well as multiplespecialists in several disciplines, complicatedequipment, days in the hospital, and weeks inrecovery. The far simpler angioplasty uses aballoon to dilate narrowed arteries, causingless pain and disability. It enables less expen-sive or specialized practitioners to treat morepeople with coronary artery disease in lowercost settings. Initially, angioplasty was used inonly the easiest cases and was much less effec-tive than surgery. Experts viewed the proce-dure with skepticism because of all the thingsit and its practitioners couldn’t do. But overtime the disruptive innovation improved. In-creasing skill and experience, together withsustaining technological innovations such asstents, have allowed angioplasty to supplantsurgery in many cases. Angioplasty can now be

Disruptions of Health Care Professions

As specialist physicians continue to concen-trate on curing the most incurable of ill-nesses for the sickest of patients, less-skilled practitioners could take on more complex roles than they are currently being allowed to do. Already, a host of over-the-counter drugs allow patients to administer care that used to require a doctor’s prescription. Nurse practitioners are capable of treating many ailments that used to require a physi-cian’s care. And new procedures like angio-plasty are allowing cardiologists to treat pa-tients that in the past would have needed the services of open-heart surgeons.

Self-care

Nurse practiti

onersPrim

ary care and family practice

physicians

Specialist and su

bspecialist physic

ians

Time

Complexity of diagnosis and treatment

Performancethat patientsneed or can use



reliably performed in stand-alone cardiac carecenters, which aren’t burdened with the tre-mendous overhead costs of hospitals.

By enabling less expensive practitioners totreat diabetes and coronary artery disease inless costly locations, these disruptive innova-tions have made health care more efficient.But more important, no compromises in qual-ity were made. On the contrary, more patientsget more care. When care is complex, expen-sive, and inconvenient, many afflictions simplygo untreated. Before the disruption of angio-plasty, for example, many people with coro-nary artery disease were not treated. Patientshad to be disabled with chest pain or at risk ofheart attack to justify the expense and inconve-nience of open-heart surgery.

We need many more such disruptions—andtoday we have them within our reach. Unfor-tunately, the people and institutions whoselivelihoods they threaten often resist them. Wesaw such resistance in the story of the portableX-ray machine. Here’s another example. An En-glish entrepreneur has developed a system forcustomizing eyeglasses quickly and efficiently.The patient puts on a pair of eyeglasses withseemingly flat lenses and an odd-looking rub-ber bulb attached to each stem. Looking at avision-test chart and covering one eye, shesqueezes the bulb on the right stem until shecan read the fine print on the chart. A mono-mer in the bulb shapes the lens until that eyecan see perfectly. She repeats the process forthe other eye. Within two minutes, she has per-fectly tailored eyeglasses—at a cost of about

$5. This is a disruptive technology. It lets pa-tients do for themselves something that histor-ically required the skill of professionals.

Predictably, the established professionsquickly mobilized to discredit the entrepre-neur’s technology, asserting that dangers suchas glaucoma might go undetected if patientscorrected their own vision and that for thelong-term well-being of patients, care of theeyes must be left in the hands of professionals.Of course this is a reasonable concern. But itframes the problem incorrectly. The problemshould be, instead, let’s find a way to allow pa-tients to correct vision for themselves whilefinding new ways for professionals to catch po-tentially serious disorders at an early stage.

Such resistance affects not only technologybut people as well. Take nurse practitionersand physicians’ assistants. Because of advancesin diagnostic and therapeutic technologies,these clinicians can now competently, reliablydiagnose and treat simple disorders that wouldhave required the training and judgment of aphysician only a few years ago. Accurate newtests, for example, allow physicians’ assistantsto diagnose diseases as simple as strep infec-tions and as serious as diabetes. In addition,studies have shown that nurse practitionerstypically devote more time to patients duringconsultations than physicians do and empha-size prevention and health maintenance to agreater degree.

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But many states have regula-tions that prevent nurse practitioners from di-agnosing diseases or from prescribing treat-ment that they are fully capable of handling.

Disruptions of Health Care Institutions

Teaching hospitals incur great costs to de-velop the ability to treat difficult, intracta-ble illnesses at the high end. In the pro-cess, they have come to overserve the needs of the much larger population of pa-tients whose disorders are becoming more and more routine. Most types of patients that occupied hospital beds 20 years ago are now being treated in more-focused care centers and outpatient clinics, doc-tors’ offices, and even at home.

In-home care

In-office ca

reOutpatie

nt clinics a

nd focused-care ce

nters

General teaching hospita

ls

Time

Complexity of diagnosis and treatment

Performancethat patientsneed or can use



The flawed rationale behind such policies isthat because nurse practitioners are not ashighly trained as physicians, they are not capa-ble of providing care of comparable quality.This is the same logic that minicomputer mak-ers used to discredit the personal computer.When a physician diagnoses a simple infec-tious disease, the patient uses only that frac-tion of the physician’s training that relates tosimple infectious diseases. Studies have shownthat nurse practitioners with comparable train-ing in simple infectious diseases can providecare of comparable quality in that tier of themarket—even though they lack training inmore complex disorders.

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Some nearsighted advocates of patients’

rights assert that nurse practitioners might nothave the judgment to recognize when a disor-der is beyond their expertise. But family prac-tice doctors recognize when they can treat adisorder and when it merits referral to a spe-cialist. Surely nurse practitioners, working ateven simpler tiers of the market, can beequipped to do the same thing. The real reasonfor blocking such disruption, we suspect, is thepredictable desire of physicians to preservetheir traditional market hegemony.

Instead of working to enable the natural up-market migration that is an intrinsic part ofeconomic progress, today’s managed care orga-nizations, insurers, and regulators have donejust the opposite. They have forced highlytrained physicians down-market to diagnoseear infections and bronchitis and have pre-vented nurse practitioners from doing thingsthat technology enables them to do perfectlywell. The result of this policy is perverse. Tomaintain their incomes, primary care physi-cians are forced to churn patients at an alarm-ing rate—frequently spending only a few min-utes with each patient. That reduces thequality and convenience of care.

This practice, which has become pervasive inmost managed care organizations, is akin towhat would have happened if some regulatorybody in the early 1980s had decreed that be-cause microprocessors were inferior in comput-ing power to wired logic circuits, all personalcomputers had to be equipped with wired logicboards, not microprocessors. Such a regulationwould have halted the industry’s progress. Thefact that we were able to use microprocessor-based computers for the jobs they were capableof handling, and wired-logic-based machinesfor the jobs for which microprocessors weren’tsuited, has been a key to the creation of high-quality, convenient, cost-effective computingfor all of us. Enabling less expensive people todo things that were previously unimaginablehas been one of the fundamental engines ofeconomic progress—and the established healthcare institutions have fought that engine toothand nail.

Solutions to the Crisis

The crisis in health care is deep, to be sure. Butthe history of other disruptive revolutions of-fers a number of suggestions for how a sys-temic transformation might be managed. Wedescribe some of these here:

Patient Welfare in Disruptive Times

How might patients fare amidst health care disruptions? The answer depends on whether competitive markets are al-lowed to work efficiently. If clinicians or patients are forced to use less expensive technologies, disaster will result. But if consumers and providers are given choices, the use of disruptive technolo-gies will migrate to those applications where they create real value.

Consider Sonosite, a Seattle-area company that makes a small, highly por-table, inexpensive ultrasound machine. The machine is good, but it is disrup-tive—it lacks the analytical features and the degree of resolution found in more expensive ultrasound equipment. If a managed care organization forced echocardiologists and OB-GYN physi-cians to use these less expensive devices for situations in which they previously have used traditional equipment, a specialist could risk missing something important, and the patient’s well-being could be compromised. But suppose in-stead that because Sonosite’s technol-ogy now makes ultrasound accessible and affordable to generalist clinicians, they could begin to provide better, more accurate care within the low-cost and more convenient context of their offices. Instead of conducting exams in which they hypothesize about what’s going on inside a patient’s body by listening

through a stethoscope or by using their fingers to probe for irregularities, they could use this simple ultrasound device that would let them see inside the body. By enabling generalists to diag-nose more quickly and with greater precision, disruptive technologies such as Sonosite’s can improve, not compro-mise, the cost, quality, and convenience of care.

Ultimately, we would expect that the disruptive portable machines will im-prove to the point that they will sup-plant the more expensive traditional ultrasound equipment in established applications as well. But the true trans-formative impact of such technologies in health care will come as they allow less expensive professionals to provide better care.

If history is any guide, the established high-end providers of products and ser-vices are likely to be articulate and asser-tive about preserving existing systems in order to ensure patient well-being. Very often, however, their eloquence reflects concerns about their own well-being. Customers have almost always emerged from disruptive transitions better off—as long as the disruptions are not forced into an old mode, but instead enable better service to be delivered in a less-costly, more convenient context.



Create—then embrace—a system wherethe clinician’s skill level is matched to the dif-ficulty of the medical problem.

Medical prob-lems range from the very simple to the verycomplex, as we’ve said. Let’s look more closelyat that range for a moment. In the simplesttiers, diagnosis and treatment can be rule-based: accurate data yield an unambiguous di-agnosis, indicating a proven therapeutic strat-egy. Many infectious diseases fall into this cat-egory. In the middle tiers, diagnosis andtreatment occur through pattern recogni-tion—no single piece of data yields an answer,but multiple data points lead to a definitive di-agnosis. The onset of Type I diabetes, for ex-ample, is diagnosed when a pattern is ob-served—blurry vision, incessant thirst, weightloss, and frequent urination. Once a diagnosisis confirmed, relatively standardized treat-ment protocols often exist. In the most com-plex disorders, diagnosis and treatment occurin a problem-solving mode. These problemsrequire the collective experience and judg-ment of a team of clinical investigators andoften involve cycles of testing, hypotheses,and experimentation.

By now it’s clear that the simplest tiers canbe reliably treated and diagnosed by lesshighly skilled clinicians—and also that institu-tional forces will fight that reality. We cannotallow such opposition to arrest reform. In-stead, we must invent processes that can chan-nel complex problems, which can’t be solved ina rule-based mode, to clinicians whose skillsare appropriate to a pattern-recognition or aproblem-solving mode.

Scientific progress moves disorders thatused to be dealt with in a problem-solvingmode toward a pattern-recognition mode andthose that had to be addressed through patternrecognition toward a rule-based regime. Map-ping the human genome will accelerate thisprocess. Not long ago, for example, leukemiawas thought to be a single disease. Diagnosingand treating it was complex—no two patientsresponded identically to the same therapy, andtreatment required the experience, intuition,and problem-solving skills of the best oncolo-gists. Our improved understanding of thehuman genetic code, however, has helped re-searchers see that what we previously calledleukemia is really at least six different diseases.Each is characterized by a specific genetic pat-tern, and patients can be precisely diagnosed

by matching their patterns to a template.Where once therapy used to be applied ex-

perimentally, such precise definition of the dis-ease will allow for precise treatment protocols.Disruptive technologies such as this are pre-cisely what are needed to reform health care.They will continue to enable less-experiencedcaregivers to make more precise diagnoses andprovide higher quality care than they couldhave in problem-solving mode.

It’s in physicians’ interest to embrace thischange. Rather than fight the nurse practitio-ners who are invading their turf, primary carephysicians should move upmarket themselves,using advances in diagnostic and therapeutictechnologies to perform many of the servicesthey now refer to costly hospitals and special-ists. They should, in other words, disrupt thoseabove them rather than fight a reactionary andultimately futile battle with disrupters frombelow.

4

Let us be clear. Many managed care or-ganizations today give primary care physiciansa financial incentive not to refer patients tospecialists—to continue treating patients theyare not competent to care for. Inviting them tomove incompetently upmarket is a recipe fordisaster. Disruptive technologies such as thosewe have described will enable these caregiversto move competently upward. These innova-tions are the sort that will reform health care.This strategy—unlike the one that pushesthese physicians down-market or encouragesthem upward without enabling technology—isconsistent with the way technological progressand customer needs interact.

Invest less money in high-end, complextechnologies and more in technologies thatsimplify complex problems. Equity marketshave not been generous to companies makinghealth care products and equipment in recentyears. Other sectors of the economy are per-ceived to exhibit greater growth and profit po-tential. One reason for this, we believe, is thatmuch of the energy and capital spent in thedevelopment of new health care products andservices have been targeted at the high end—at sustaining technologies that enable themost skilled practitioners to solve problemsthat could not be solved before. We do notcontest the value of these innovations—butthey will not transform health care. The greatgrowth opportunities exist in the simpler tiersof the market. History tells us that major newgrowth markets coalesce when products, pro-

When care is complex,

expensive, and

inconvenient, many

afflictions simply go

untreated.



cesses, and information technologies let lesshighly paid groups of people do things in moreconvenient settings. To truly disrupt thehealth care system, venture capital, entrepre-neurial energy, and technology developmentneed to flow toward these enabling initiatives.Rather than focus on complex solutions forcomplex problems, research and developmentneed to focus on simplification.

It’s not entirely clear why more venture cap-ital hasn’t flowed in this direction. One possi-ble reason is that individual entrepreneurialcompanies don’t get to pick fights with individ-ual Goliaths—more often, they face an army ofgiants. Because regulators, litigators, insurers,physicians, hospitals, and medical schools havesuch powerful interlocking interests in the sta-tus quo, disruption might require the con-certed strategic focus of major health carecompanies such as Johnson & Johnson, Baxter,Medtronic, or Merck. Over time, they couldovercome the inertia of entrenched institu-tions. A series of disruptive business ventureslaunched by these companies would create fargreater growth for them, with less investment,than would continued pursuit of sustainingtechnologies that enable specialists to pushfurther into high-end complexities.

Create new organizations to do the dis-rupting. The health care industry today is try-ing to preserve outmoded institutions. Yet thehistory of disruptive innovations tells us thatthose institutions will be replaced, soonenough, with new institutions whose businessmodels are appropriate to the new technolo-gies and markets.

When disruptive innovations have invadedthe mainstream markets of other industries, adifficult period typically has preceded the ar-rival of truly convenient, lower cost, higherquality products and services. Between 1988 and1993, for example, as networked personal com-puters became the dominant information tech-nology architecture, the former industry leadersfell into disarray. Together, the mainframe andminicomputer makers logged $20 billion in op-erating losses during that period. None of thesecompanies was able to adapt its business modelto compete in the personal computer world. In-stead, they seemed able only to tighten thethumbscrews on their existing processes, attack-ing costs through mergers and layoffs, as theywithered away. During this period, it wasn’t thecomputer industry that was in crisis—only its

traditional institutions were. Disruptive innova-tors such as Intel, Sun, Microsoft, and Dell werecreating extraordinary value.

The massive financial losses that hospitalsand managed care institutions are sufferingtoday mirror exactly what happened to thedominant players in other disrupted industries.And they are responding in the same way—bytightening controls on their existing businessmodels. They are merging, closing facilities, lay-ing off workers, forming buying groups, delay-ing payments, adding layers of control-orientedoverhead workers, and hiring consultants—while going about their work in a fundamen-tally unchanged way. In fact, the billions of dol-lars large general hospitals are spending to buildinformation technology systems and to createintegrated feeder systems of physicians’ grouppractices and primary-, secondary-, and tertiary-care hospitals are designed to preserve, ratherthan displace, the existing institutions.

We will always need some general hospitalsto provide intensive and critical care to thesickest patients, just as we still need IBM andHitachi to make mainframe computers for themost complex computing applications. But it isvery likely that the care of disorders that pri-marily involve one system in the body—fromearaches to cardiac and renal illnesses—willmigrate to focused institutions whose scopeenables them to provide better care with lesscomplexity-driven overhead. If history is anyguide, the health care system can be trans-formed only by creating new institutions thatcan capably deliver the vast majority of suchcare, rather than attempting a tortuous trans-formation of existing institutions that were de-signed for other purposes.

Leaders of today’s hospital and managedcare companies might profit from comparingthe approaches that S.S. Kresge and F.W. Wool-worth took toward disruptive discount retail-ing, beginning in the early 1960s, as recountedin Clayton Christensen’s The Innovator’s Di-lemma. Kresge addressed the disruption by sys-tematically closing 10% of its variety storesevery year and funneling all its cash into its dis-ruptive start-up, Kmart. Woolworth, by con-trast, tried to maintain its pace of investmentin its traditional stores while building its dis-count-retailing arm, Woolco. Despite the factthat Woolworth was far larger and had muchdeeper pockets, Woolco—and ultimately all ofWoolworth’s variety stores—folded. The les-



sons for today’s medical institutions: don’t bescared to invent the institution that could putyou out of business, and stop investing in dyingbusiness models.

Overcome the inertia of regulation. At-tempts to use regulation to stave off disruptiveattacks are quite common. The U.S. automak-ers, for example, relied on import quotas aslong as they could to keep disruptive Toyotaand Honda at bay. Unfortunately, regulatorsare inclined to be even more protective of theentrenched professions and institutions inhealth care than they were of the U.S. automak-ers. The links between those institutions, fed-eral and state regulators, and insurance compa-nies are strong; they are wielded to preserve thestatus quo. (Nothing else could explain whynurse practitioners are forbidden from diagnos-ing simple illnesses in so many states.)

Instead of working to preserve the existingsystem, regulators need to frame their jobs dif-ferently. They need to ask how they can enabledisruptive innovations to emerge. Let’s returnto the example we began with—the low-cost X-ray machine. Suppose the regulators wanted tosee this disruptive innovation work in doctors’offices but were concerned about potentialrisks. They might require that all images inter-preted in a physician’s office by a nonradiolo-gist be transmitted via the Internet to a second-opinion center, where skilled radiologists couldconfirm those initial diagnoses. Admittedly,that would require a massive change in theway regulators do their work.

The Need for Leadership

Once an industry is in crisis, individual leadersoften become paralyzed. They’re incapable of em-bracing disruptive approaches because the profit-ability of the institutions they lead has been soeroded. Typically, not only do they ignore the po-tential disruptions, they actively work to discreditand oppose them. Thus far, this pattern has heldtrue in the health care industry as well.

Successful disruptive revolution of this sys-tem will unfold more quickly, and far less pain-fully for everyone, if leaders at regional and na-tional levels work together—not to regulate theexisting system but to coordinate the removal ofthe barriers that have prevented disruptionsfrom happening. Unfortunately, in this presi-dential election year, the proposals from bothleading parties for dealing with the crisis inhealth care have been molded within the estab-

lished system. These proposals can be dividedinto three categories of solutions: control costsby consuming less health care; impose reim-bursement controls that force high-end provid-ers to become more efficient; and use govern-ment money to subsidize the high costs ofhealth care for targeted segments of the popula-tion. None of these proposals addresses the fun-damental causes of the dilemmas that thehealth care system faces.

Government and health care industry lead-ers need to step forward—to help insurers, regu-lators, managed care organizations, hospitals,and health professionals work together to facili-tate disruption instead of uniting to prevent it.If they do, some of the established institutionswill fail. But many more health care providerswill realize the opportunities for growth thatcome with disruption—because disruption isthe fundamental mechanism through which wewill build a higher quality, more convenient,and lower cost health care system. If leaderswith such vision do indeed step forward, we willall have access to more health care, not less.

The authors express appreciation to Jeff Eltonand his staff at Integral, Incorporated for theircontributions to this article.

1. Clayton M. Christensen,

The Innovator’s Dilemma: WhenNew Technologies Cause Great Firms to Fail

(Harvard Busi-ness School Press, 1997).

2. See James Lardner, “For Nurses, a Barrier Is Broken,” U.S.News & World Report, July 1998.

3. Richard A. Cooper, MD, et al. “Roles of Non-physicianClinicians as Autonomous Providers of Patient Care,” JAMA,September 2, 1998. These market forces are already atwork. It is estimated that by the year 2005, the number ofnurse practitioners in clinical practice will equal the num-ber of family physicians. Between 1992 and 1997, the num-ber of schools offering qualification programs for NPs morethan doubled, from less than 100 to approximately 250.During that same time, the number of students pursuingNP degrees quintupled, from 4,000 to over 20,000.

4. Evidence that specialists are already being disrupted inthis manner can be found in a 1995 report by the Council ofGraduate Medical Education, which predicted an excess of115,000 specialists by the year 2000. See Stephen M. Short-ell et al., Remaking Health Care in America: Building Orga-nized Delivery Systems (Jossey-Bass Publishers, 1996), p. 298.

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Further Reading

A R T I C L E S

Disruptive Technologies: Catching the Wave

by Joseph L. Bower and Clayton M. Christensen


January–February 1995Product no. 3510

The authors examine more closely what can happen to companies that ignore

disruptive innovations—and offer guidelines for avoid-ing that fate. Established firms often reject disruptive technologies. Why? Their most profitable, high-end customers want more sophisticated technologies. And, the new technologies’ projected profit margins won’t cover their big-company cost structures. While they’re ignoring the disruptive innova-tions, upstart companies step in to bring these cheaper, simpler, more convenient products to less-demanding markets. Over time, these products improve to meet the needs of high-end customers as well. By the time established firms recognize disruptive threats, their competitive opportunities have been lost.

To prevent disruptive technologies from slip-ping through their fingers, established corpo-rations must identify and nurture innovations on a more modest scale—so small orders are meaningful, ill-defined markets have time to mature, and overhead is low enough to per-mit early profits.

Transforming Life, Transforming Business: The Life-Science Revolutionby Juan Enriquez and Ray A. GoldbergHarvard Business ReviewMarch–April 2000Product no. R00203

Where will the next disruptive innovations in health care come from? Enriquez and Gold-berg argue that genetic engineering will not only revolutionize the practice of medicine, benefiting individuals and societies every-where—it will also reshape vast sectors of the world economy. Ultimately, it will subsume health care (and other industries such as agri-business, chemicals, and pharmaceuticals) into what promises to become the largest industry in the world: life sciences.

As genetic advances continue to accelerate, more and more businesses will be drawn—by choice or by necessity—into the life-science industry. Firms must rethink their business, financial, and M&A strategies, as well as make vast R&D investments with dis-tant and uncertain payoffs. The actions com-panies take now will go a long way toward determining the ultimate role they play in this emerging industry.

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