Chapter by Peter M. Senge: The puzzles and Paradoces of How Living Companies Create Wealth

Senge starts of by saying that Jensen argues that firm value maximization is optimal (p. 59). He says Jensen argues that it isn’t possible to maximize in more than one dimension at the same time, according to Jensen there are trade-offs between those dimensions. That’s what an singe-valued objective function does. People need a measure for what is sought in order to make sound choices balancing short-term and long-term gains, giving up on one objective in favor of another or drawing a line where costs exceed benefits.

It is according to Senge not so surprising that Jensen is critical of concepts as balanced scorecards and stakeholder theories because they often present competing goals. According to Jensen these ideas are incomplete because they give no measure to people on how to make choices (p. 60). Jensen also points to the fact that maximizing total value isn’t the same as maximizing shareholder return, there might be other sources of financial capital than equity. Therefore value maximization should always consider all of society’s claims on the firm. Senge admits to agreeing with many aspects of this argument. He specifically agrees to the fact that most businesses don’t care as much about profits as they claim to do. In his own observation he encountered that profits are frequently down the line among priorities driving the decisions; right after politics, power and habit. These other ‘priorities’ are often influencing other peoples decision making, they lower commitment and devastate the energy of employees.

According to Senge, most people care about teamwork and an excelling organization and they are therefore frustrated when their management isn’t competent or focused on the health of the entire enterprise. People accept this way too often and work becomes just a job. As an answer to this problem (self-serving managers not creating wealth and not serving customers), a generation of “results-oriented” CEOs has emerged (p. 61). Senges concern is that these CEOs make matters worse quite frequently; they leave enterprises less able to focus on shareholder value by shifting attention to their leadership instead of growing capabilities inside of the enterprise. Senges fear is that these “tough business leaders” undermine long-term generation of wealth by creating environments of fear that stress short-term goals.

In the last part of the introduction, Senge states that he thinks that Jensen shares many of these concerns. But, there are also some differences between the two authors. Senge sees two sets of problems with Jensens argument that what firms need is “single-valued objective functions and a clear focus on maximizing value”. The first one is instrumental, concerning operationalizing, and the second one is objective, concerning the aim itself.

Instrumental Problems with Value Maximization

The problem is: “Accepting that increasing firm value is a legitimate overarching aim, it is unclear how management can best focus people’s efforts and attention in order to reliably achieve progress in this direction.” (p. 61).

Predictiveness Issues

The background of Senge is in nonlinear dynamic systems. Studying this led him to conlude that you don’t optimize anything, becaue those systems are by nature nonpredictive (p. 62). The problem with these nonlinear dynamic systems is that even a ‘perfect mode’ is not predictive because the problem is inherent in the characteristics of nonlinear multiple-feedback-loop dynamic systems.

Some of these ideas are recognized as coming from chaos theory. Senge first came to understand these prediction-problems from a computer experiment in Jay Forrester’s book Industrial Dynamics. The implications of this experiment were of great importance; even a perfect model could not be expected to even be close to matching the referent systems behavior over time. This problem is related to the character of nonlinear dynamics and therefore it is not expected that predictability will ever increase.

Senge never thought any more about optimization because of the impact of this experiment. If a perfect model can’t even estimate the future of a system, how can a imperfect model (employed in real settings) do anything? What then does it mean to identify factors for optimization if we are not able to predict the consequences?

Why Learning Is More Important Than Optimizing

According to Senge it is important to focus on learning how things can get better over time, instead of analyzing, because we live in a nonlinear world (p. 63). Forrester’s experiments showed that a more qualitative approach is needed to understand and improve complex human systems. Patterns of behavior generated by the simulations in the experiment were fairly similar. Even though you couldn’t predict outcomes, one could be superior to the other. These findings suggested an approach for understanding long-term consequences of alternatives in a nonlinear system: “Results caanot be predicted precisely, but the patterns shaping them can be understood.” (p. 63).

Because of these findings, Senge thinks that learning should be prioritized over optimizing. Management shouldn’t be trying to find the right answer, they should understand consequences and head in an intended direction, this could lead to significant improvement.

Jensen’s response to these problems is that a single-valued objective function still makes sense because people still make trade-offs and having a share idea of the definition of ‘better’ still matters (p. 64). Senge agrees on the fact that people need a shared definition of ‘better’, but he says that agreeing on the objective function is just a small problem. He particularly worries that a sole focus on increasing firm value will in reality reduce the possibility of achieving that. This concern is based on causal theories, which are unexamined and questionable, but will remain unexamined unless management will shift its focus to learning.

The System Dynamics View of People’s Theories in Use

“The counter-intuitive nature of complex systems”, a phenomenon called out by Forrester, meaning that conscious policies in complex systems are often a source of problems (p. 64). Senge points out that Forrester used to say that people focus on parts of the complex system where low leverage for change exists. Forrester implicates that almost all organizations underperform and that being more clear about goals won’t do much to help.

John Sterman has explored these problems with “human decision making” in experiments. He concluded that people misdjudge even simple decision-making tass and contributed to the literature (on decision-making) that “there appear to be “basic cognitive limits” to our abilities to understand the dynamics of nonlinear multiple-feedback-loop systems” (p. 65). When confronted with dynamic complexity, people usually are misled by their mental frame of simple linear cause and effect.

Both Forrester and Sterman argue that the inadequacy of the causal theories guiding our actions, is the key problem. People should become “more reflective on the reasoning that guides our actions and to gradually improve our theories in use”. This is a learning challenge which, according to Senge, undermines the bigger problem. We should convince people to improve firm value.

Senge comes up with another implication of the system dynamics view; firm value maximization will nearly always become short-term profit maximization. Complex feedback dynamics need time, if you only take into account a short time horizon, many of these feedbacks can and will be ignored. According to Senge preaching value maximization will almost always get you short-term profit maximization. It will only be otherwise if causal theories are examined and learning is in play.

The Immensity of the Learning Challenge in Realistic Settings

Senge encounters preaching learning as problematic. In real life, “unarticulated and simplistic individual mental models” (p. 66) interact with the complexity of group dynamics and the social dimension. Senge illustrates this statement with an example from his own workexperience. He and his colleagues came to the conclusion that several managerial practices in the company were flawed (p. 66). Quality in the company was dropping, higly subjective quality (p. 67). After this research, subsequent studi showed in both 1996 and 1999 that similar vicious spirals were encountered in other service businesses (p. 67). Senge says that if quality is subjective and not easily brought under control of quantitative measures, a vicious spiral might develop: “underinvestment in professional capacity, erosion of quality standards, and increasing financial pressures due to rising costs of poor quality”.

Senge concluded that the demands (both emotional and cognitive) to increase the profitability in this case, were too much for the capacity of the group. This limited capacity confined the area of decisions possible (p. 69). Senge admits that there is a slight possibility of him being wrong, but the whole point of this example was to explain why improving causal theory is important. According to Senge this is the kind of “learning challenge” organizations face all the time (p. 70). Last but not least Senge is making a critical statement about Jensen, saying that Jensen ignores the problem and simply preaches avlue maximization (p. 70).

What Can Management Do to Help People Focus Their Efforts Productively?

Senge gives some suggestions on what management can do.

Focusing efforts might not lead you directly to your goal, management should be able to construct local goals to achieve the overarching aim (p. 71). To illustrate this Senge shortly talks about Toyota and quotes Deming, who is saying that numerical goals should be eliminated (p. 71).

People are interested in learning even if there aren’t any external pressures (p. 72). Deming and Toyota both seem to support this statement, people have intrinsic motivation and management should build on that.

Learning and working should be intertwined (p. 72). Senge uses Johnson (2000) to support this statement. Johnson says that Toyota has emerged into some kind of a living system. Therefore, there is a natural learning process going on and management should find a way to improve and speed up those processes.

Local goals or quantitative targets aren’t forbidden, people will often set their own targets if they are motivated to learn (p. 73).

Senge and colleagues concluded in their own work that a manager’s job should include creating an envorinment in which three types of learning can be developed: individual and collective aspiration, reflectiveness and generative conversation, and systems thinking (p. 73).

Two fundamental gaps are identified by Senge that characterize the struggles of encouraging learning to increase firm value: first of all managers’ theories might not match their espoused theories and secondly people’s theories might be poor guidance for decision-taking (p. 74).

Senge thinks that Jensen and himself may agree that management should improve learning processes (p. 75). He doesn’t have a problem with building firm value as an aspiration (Jensen), but his main concern comes from a misplaced emphasis on value maximization if it is taken away from larger learning processes (p. 75).

Objective Problems with Value Maximization

In the introduction Senge said he had two sets of problems. The second problem raises questions about the aim of value maximization (p. 75). Senge suggests that if we think about organizations as living systems (and not as machines) it will lead us to a different understanding of the role of profits and value.

The Living Company

A retired Shell executive (Arie de Geus) wrote a book raising issues about seeing a company as a living being (p. 76). We see organizations as machines because we grew up in an industrial society according to Senge. A difference between a machine and a living system is that living systems create. Machines on the other hand are created. Companies are, therefore, ambiguous (p. 76), they are created by their founders but they also act as a human community.

De Geus says that companies that have survived for a long time are tempted to see themselves more as living beings than as machines (p. 76). Companies have a sense of identity, a purpose, and core values.

Purpose and Function: Rethinking Value Maximization in a Living Company

But how is this living company idea related to value maximization (p. 77)? Senge makes yet another biological distinction; design versus emergence. Living beings have some basic functions that are created by the organism itself and not by design (p. 77). The full set of capabilities of a living system comes from the interplay of design and emergence (p. 78).

By distinguishing design and emergence, Senge makes a distinction between function and purpose. Function has two meanings: design of the organism and fit into larger systems of the organism (p. 78). Purpose on the other hand is emergent, it can never be specified by a designer (p. 78).

Value maximization could be seen as the function of the organization within society (p. 78). This will only change if the design is substantially changed. But, because organizations are living systems, this design is subject to emergence (p. 78). In conclusion; design and emergence coexist and interact inside a living system. Therefore, creating firm value and actualizing purpose can coexist.

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