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DAVID LEVY
Strategic Management Journal, Vol. 15, 167-1 78 (1994)
This paper argues that chaos theory provides a useful theorectical framework for
understanding the dynamic evolution of industries and the complex interactions among
industry actors. It is argued that industries can be conceptualized and modeled as complex,
dynamic systems, which exhibit both unpredictability and underlying order. The relevance
of chaos theory for strategy is discussed, and a number of managerial implications are
suggested. To illustrate the application of chaos theory, a simulation model is presented
that depicts the interactions between a manufacturer of computers, its suppliers, and its
market. The results of the simulation demonstrate how managers might underestimate the
costs of internationalproduction. The paper concludes that, by understanding industries as
complex systems, managers can improve decision making and search for innovative
solutions.
CCC 0143-2095194/090167-12
@) 1994 by John Wiley & Sons, Ltd.
168 D.Levy
noted that social, ecological, and economic have confounded mathematicians for years. A
systems also tend to be characterized by nonlinear similar problem afflicts someone who is trying
relationships and complex interactions that evolve to calculate the path of an object in the
dynamically over time. This recognition has led gravitational pull of two or more bodies. While
to a surge of interest in applying chaos theory to we can use simple Newtonian equations to predict
a number of fields, including ecology (Kauffman, the orbits of planets around the sun with a high
1991), medicine (Goldberger, Rigney and West, degree of accuracy, the mathematics involved in
1990) international relations (Mayer-Kress and the case of two or more ‘suns’ become intractable.
Grossman, 1989), and economics (Baumol and The problem can be illustrated on a terrestrial
Benhabib, 1989; Kelsey, 1988).’ Despite the level by observing the motion of a simple toy, a
apparent applicability of chaos theory to the field metal ball suspended over two or more magnets.
of business strategy, there has been surprisingly The ball will trace a series of patterns that never
little work in this area. exactly repeat themselves, and yet are not totally
This paper introduces readers to chaos theory, random.
and discusses its relevance to the social sciences The paradox here is that the motion of the
in general and to aspects of strategy in particular, metal ball is driven by the same Newtonian
including planning and forecasting, and the equations as the well understood case of a single
impact of change on firms and industries. The gravitational attractor. If we knew precisely the
application of chaos theory to a business situation original location, speed, and direction of the
is illustrated using a simulation model of an ball, we ought to be able to predict its path with
international supply chain. The model, which is a reasonable degree of accuracy. How is it
based on the author’s research into the supply that deterministic systems can give rise to
chain of a California-based computer company, unpredictability? The explanation is that tiny
depicts the complex interactions between the variations in the motion of the ball are magnified
firm, its suppliers, and its markets. The simulation every time it swings by one of the magnets. It
results illustrate the managerial implications of is a combination of this divergence and the
applying chaos theory to strategic management. repeated interactions that give rise to ‘chaotic’
The model demonstrates how small disruptions behavior. Mathematically, chaotic systems are
to the supply chain interact to make the chain represented by differential equations that cannot
highly volatile, imposing significant costs on the be solved, so that we are unable to calculate the
organization. Although forecasting is very difficult state of the system at a specific future time ‘t’.
in the supply chain, distinct patterns emerge At the limit, chaotic systems can become truly
which are useful for managers. The simulation random. A toss of a coin or the roll of a die
also shows that by understanding the supply are, in theory, deterministic systems, but yield
chain as a complex dynamic system, it is possible more or less random outcomes. Not only is it
to identify managerial approaches that lower the impossible to toss a coin twice in exactly the
cost of operating the supply chain. same way, but on each toss the coin is subject
to slightly different air currents, themselves a
result of turbulent air flow (Ford, 1983).
AN INTRODUCTION TO CHAOS To overcome the problem of intractable differ-
THEORY ential equations, researchers usually model sys-
tems as discrete difference equations, which
Chaos theory is the study of complex, nonlinear, specify what the state of the system will be at
dynamic systems. The field was pioneered by time ‘t+l’ given the state of the system at time
Lorenz (1963), who was studying the dynamics ‘t.’ Computer simulations can then be used to
of turbulent flow in fluids. Although we all see how the system evolves over time.
recognize the swirls and vortices that characterize One of the major achievements of chaos theory
turbulent flow, the complexities of turbulent flow is its ability to demonstrate how a simple set of
deterministic relationships can produce patterned
yet unpredictable outcomes. Chaotic systems
I See also special issues of Journal of Economic Theory,
40(1), 1986, and Journal of Economic Behavior and Organiza- never return to the same exact state, yet the
tion, 8(3), 1987. outcomes are bounded and create patterns that
Chaos Theory and Strategy 169
embody mathematical constants (Feigenbaum, reflect very complex underlying relationships that
1983). It is the promise of finding a fundamental include the interaction of several potentially
order and structure behind complex events that chaotic systems; crop prices, for example, are
probably explains the great interest chaos theory influenced by the interaction of economic and
has generated in so many fields. weather systems. The search for a simple set of
equations to explain complex phenomena may
be a futile attempt to construct grand ‘meta-
Chaos theory and the social sciences
theory,’ a project that is rejected in the postmod-
Proponents of chaos theory enthusiastically see ern paradigm. The application presented here
signs of it everywhere, pointing to the ubiquity uses a different approach; field study research is
of complex, dynamic systems in the social world used to derive a set of relationships among
and the resemblance between patterns generated variables and the influence of external systems
by simulated nonlinear systems and real time is modeled probabilistically , a method suggested
series of stock exchange or commodity prices. by Kelsey (1988).
From a theoretical perspective, chaos theory is Social and physical systems also differ in the
congruous with the postmodern paradigm, which source of unpredictability. In the physical
questions deterministic positivism as it acknowl- world, unpredictability arises due to many
edges the complexity and diversity of experience. iterations, nonlinearity, and our inability to
While postmodernism has had a profound influ- define starting conditions with infinite precision.
ence on many areas of social science and the In the social world, far less accuracy is
humanities, it has been neglected by organization possible in defining starting conditions, and the
theorists until very recently (Hassard and Parker, specification of the system structure itself is
1993). much less precise.
Despite its attractions, the application of chaos A final difference is that physical systems
theory to the social sciences is still in its infancy, are shaped by unchanging natural laws, whereas
and there are those who think that expectations social systems are subject to intervention by
are too high (Baumol and Benhabib, 1989). individuals and organizations. Investigations of
Although real life phenomena may resemble the economic time series by chaos theorists have
patterns generated by simple nonlinear systems, usually assumed that relationships among eco-
that does not mean that we can easily model nomic actors are fixed over time. In reality,
and forecast these phenomena; it is almost methods of stabilizing the economy have
impossible to take a set of data and determine changed from the use of the gold standard
the system of relationships that generates it and balanced budgets to Keynesian demand
(Butler, 1990). In fact, there is considerable management and, later, to monetarist contols.
debate in the economics and finance literature Human agency can alter the parameters and
about how one tests a data series to determine very structures of social systems, and it is
if it is chaotic or simply subject to random perhaps unrealistically ambitious to think that
influences (Brock and Malliaris, 1989; Hsieh, the effects of such intervention can be endo-
1991). Moreover, it is important to recognize genized in chaotic models.* Nevertheless,
that many systems are not chaotic, and that chaotic models can be used to suggest ways
systems can transition between chaotic and that people might intervene to achieve certain
nonchaotic states. Chaos theory is perhaps better goals. The application presented here, for
seen as an extension of systems theory (Katz example, shows how management can reduce
and Kahn, 1966; Thompson, 1967) into the realm the volatility of the supply chain to improve
of nonlinear dynamics rather than as a total performance.
paradigm shift.
It is possible that the application of chaos
theory to social science has been constrained by To some extent, the distinction between endogenous and
the fact that it has developed in relation to exogenous variables in a model is one of convenience; a
physical systems, without taking into account factor that is exogenous in a simple model might become
endogenous in a more complex and comprehensive one.
fundamental differences between physical and Exogenous factors can be included as random variables in
social science. In the social world, outcomes often chaotic systems for modeling purposes (Kelsey. 1988).
170 D.Levy
RELEVANCE OF CHAOS THEORY TO errors would lead us to think that better models
STRATEGY and a more accurate specification of starting
conditions would yield better forecasts, useful
To understand the relevance of chaos theory to for perhaps months if not years into the future.
strategy, we need to conceptualize industries as Chaos theory suggests otherwise; the payoff in
complex, dynamic, nonlinear systems. Firms terms of better forecasts of building more
interact with each other and with other actors in complex and more accurate models may be small.
their environment, such as consumers, labor, the Similarly, we cannot learn too much about the
government, and financial institutions. These future by studying the past: if history is the sum
interactions are strategic in the sense that of complex and nonlinear interactions among
decisions by one actor take into account antici- people and nations, then history does not repeat
pated reactions by others, and thus reflect itself. Concerning urban planning, Cartwright
a recognition of interdependence. Although (1991) has noted that we have to acknowledge
interfirm behavior has been modeled formally in that ‘a complete understanding of some of the
economics and business strategy using game things we plan may be beyond all possibility.’
theory (Camerer, 1991), these models tend to The notion that long-term planning for chaotic
presume the emergence of equilibrium and do systems is not only difficult but essentially
not adequately reflect industry dynamics. As impossible has profound implications for organi-
Porter (1990) emphasizes, the evolution of zations trying to set strategy based on their
industries is dynamic and path dependent: corpor- anticipation of the future. Rather than expend
ate (and country-level) capabilities acquired large amounts of resources on forecasting, stra-
during previous competitive episodes shape the tegic planning needs to take into account a
context for future competitive battles. Moreover, number of possible scenarios. Moreover, too
the accumulation of competitive advantage can narrow a focus on a firm’s core products
be self-reinforcing, suggesting at least one way and markets might reduce the ability of the
in which industries are nonlinear. If industries organization to adapt and be flexible in the face
do behave as chaotic systems, a number of of change. The proliferation of joint-ventures
implications for strategy can be drawn. and the acquisition by large firms of stakes
in entrepreneurial enterprises can perhaps be
understood as attempts to keep a foothold in a
Long-term planning is very difficult
number of potential scenarios in the face of
In chaotic systems, small disturbances multiply uncertainty and accelerating change.
over time because of nonlinear relationships and
the dynamic, repetitive nature of chaotic systems.
industries do not reach a stable equilibrium
As a result, such systems are extremely sensitive
to initial conditions, which makes forecasting The traditional approach to understanding the
very difficult. This is a problem that has influence of industry structure on firm behavior
confronted meteorologists trying to model the and competitive outcomes has been derived
weather: the fundamental problem is trying to from microeconomics, with its emphasis on
use finite measurements in an infinite world. comparative statics and equilibrium. More recent
A related problem is that as systems evolve applications of game theory have attempted to
dynamically, they are subject to myriad small account for interactions among small numbers of
random (or perhas chaotic) influences that cannot firms (usually two), yielding predictions about,
be incorporated into the model. for example, investments in R&D or plant
Formulating a long-term plan is clearly a key capacity to seize first-mover advantages. Even
strategic task facing any organization. People the most complex game theoretic models, how-
involved in planning, whether in business, eco- ever, are only considered useful if they predict
nomics, or some other area, have always known an equilibrium outcome. By contrast, chaotic
that models are always just models, that forecasts systems do not reach a stable equilibrium; indeed,
are uncertain, and that uncertainty grows over they can never pass through the same exact state
time. Nevertheless, our conventional understand- more than once. If they did, they would cycle
ing of linear models and the influence of random endlessly through the same path because they
Chaos Theory and Strategy 171
are driven by deterministic relationships. The disasters to account for economic depressions or
implication is that industries do not ‘settle down’ a crash in the stock market.
and any apparent stability, for example in pricing The size of fluctuations from one period to
or investment patterns, is likely to be short lived. the next in chaotic systems have a characteristic
Chaos theory also suggests that changes in probability distribution (Bak and Chen, 1991).
industry structures can be endogenous. Corporate Under this distribution, large fluctuations occur
decisions to enter or exit the market, or to more frequently than under the normal distri-
develop new technologies, alter the very structure bution, suggesting that managers might underesti-
of the industry, which in turn influences future mate the potential for large changes in industry
firm behavior. One of the most provocative and conditions or competitors’ behavior.
controversial elements of chaos theory is that Small exogenous disturbances to chaotic sys-
chaotic systems can spontaneously self-organize tems can also cause unexpectedly large changes.
into more complex structures (Allen, 1988). The The implication for business strategy is that the
notion has been applied to biological evolution entry of one new competitor or the development
(Laszlo, 1987) as well as to economic systems of a seemingly minor technology can have a
(Mosekilde and Rasmussen, 1986). In the context substantial impact on competition in an industry.
of business strategy, the concept could potentially An example that comes to mind is the way Dell’s
be applied to the evolution of complex organiza- mail order strategy in the personal computer
tional relationships such as long-term contracts industry forced other companies to reduce their
and technical cooperation with suppliers, and prices and reexamine their traditional high-cost
hybrid forms of organizational control such as sales and service channels.
joint ventures. Chaos theory suggests that new,
more complex organizational forms will appear
Short-term forecasts and predictions of patterns
more frequently than if they were simply the
can be made
result of random mutations.
Although the unpredictability and instability of
chaotic systems has been emphasized, there is
Dramatic change can occur unexpectedly
also a surprising degree of order in chaotic
Traditional paradigms of economics and strategy, systems. Short-term forecasting is possible
which are generally based upon assumptions of because in a deterministic system, given the
linear relationships and the use of comparative conditions at time ‘t,’ we can calculate the
static analysis, lead to the conclusion that conditions at time ‘t+ 1.’ A carefully constructed
small changes in parameters should lead to simulation model of a complex system with
correspondingly small changes in the equilibrium accurately specified starting conditions can yield
outcome. Chaos theory forces us to reconsider this useful forecasts at least for several time periods.
conclusion. Large fluctuations can be generated Weather forecasts based on sophisticated com-
internally by deterministic chaotic systems. Mod- puter models using measurements from thousands
els of population growth based on the logistic of points around the globe do provide useful
difference equation illustrate how sudden, large forecasts for a few days, which is usually sufficient
changes in population levels can arise from the for purposes such as hurricane warnings. If we
dynamics of the system rather than from the imagine that strategic decisions in companies are
influence of external shocks (Radzicki, 1990).3 made on a monthly or even annual cycle, then
Similarly, if economic systems are chaotic then industry simulation models might be able to
we do not need to search for wars or natural make useful predictions over a time horizon of
several months or possibly years.
Another feature of chaotic systems that lends
them a degree of order is that they are bounded;
The logistic difference equation has the form:
P,,, = P, * R* (I-P,) outcome variables such pricing or investments in
P, a fraction between 0 and 1, represents the population new capacity fluctuate within certain bounds that
level as a proportion Of the maximum carrying capacity Of are determined by the structure of the system
the environment. R is the growth rate from one cycle to the
next. Population growth is constrained by the factor and its parameters but not its initial conditions.
which can be understood as a resource constraint. In the context of bushes strategy these bounds
172 D.Levy
might be set by feedback loops such as the between countries, between firms in an industry,
entrance of new firms or antitrust action by or even between departments in a firm.
the government in response to monopolistic
conditions.
Guidelines are needed to cope with complexity
Although we cannot forecast the precise state
and uncertainty
of a chaotic system in the longer term, chaotic
systems trace repetitive patterns which often ‘Strategy’ can refer to a set of guidelines that
provide useful information. According to Rad- influence decisions and behavior. It is the
zicki (1990), deterministic chaos ‘is characterized complexity of strategic interactions, whether in
by self-sustained oscillations whose period and chess, soccer, or in business, that makes it
amplitude are nonrepetitive and unpredictable, essential to adopt simplifying strategies to guide
yet generated by a system devoid of randomness.’ decisions; even the most powerful computers are
For example, while we do not know exactly unable to track all possible moves and counter-
where or when tornadoes and hurricanes will moves in a chess game. General Electric’s well
strike, we do know what conditions lead to their known strategy of being number one or number
occurrence, when and where they are most two in every industry in which it participates is
frequent, and their likely paths. In a similar way, a simple example of a guideline which may be
we know that oligopolistic industries tend to generally useful but is not always optimal in
alternate between periods of intense competition every situation. We need general guidelines
and periods of more cooperative behavior, though because it is impossible to specify the optimal
we do not know when an industry will make the course of action for every possible scenario.
transition from one state to another. To give a It is important to distinguish the guidelines
third example, we know that the economy cycles and patterns of behavior that constitute strategy
through recessions and booms, though we cannot from the underlying rules of the game. In a
predict very well the depth or duration of a game of chess, for example, knowing the rules
particular recession (Butler, 199). Observing for playing the game does not necessarily give
patterns is especially useful if we can associate one insights into strategies for successful play.
different phases of the system with other charac- One can only learn these strategies after experi-
teristics; for example, there is a strong relationship encing the complexities of interactions on the
between business cycles and other variables such chess board. Indeed, because of the complexity
as demand, interest rates, the availability of of strategic interactions, one does not always
credit, vendor lead times, and the tightness of know why a particular strategy is successful.
the labor market. While the complexity of industry systems
An intriguing aspect of the patterns traced by dictates the need for broad strategies, the dynamic
chaotic systems is that they are independent of nature of chaotic systems mandates that strategies
scale; in other words, similar patterns are traced adapt. As industry structures evolve and competi-
by a system whatever horizon is used to view it, tors change their strategies, a firm clearly needs
Economic time series often appear to display to change its own guidelines and decision rules.
this property. Stock prices, for example, display a The problem here is that there is no simple way
remarkably similar pattern whether one observes of deriving optimal strategies for a given system.
daily changes over 1 year or minute-by-minute Indeed, in a complex system the best strategies
changes over a day. These images of patterns might achieve goals indirectly and even appear
within patterns are termed fractals when they counter-intuitive. The best way to improve quality
are generated by chaotic systems. In the natural is not necessarily to check every product several
world, fractals can be found in many phenomena, times: it may be to improve labor relations and
from the shape of coastlines to ice crystals. The thus gain labor’s cooperation in finding ways to
implications for business strategy are not entirely reduce defects. IBM’s decision in 1981 to
clear. One interpretation is that previous experi- let other ‘clone’ manufacturers use the DOS
ences in an industry are likely to recur on a operating system for personal computers helped
much larger scale. A second interpretation is competitors but also indirectly helped IBM to
that similar patterns of behavior might be build market share by creating the industry
expected whether one examines competition standard.
Chaos Theory and Strategy 173
In order to understand indirect or counter-
intuitive means to an end, a system needs to be
VENDORSI I<- - ORDERS TO VENDORS <--I
CL
I
i
I
disruptions to the chain rather than shorten lead TARGET COMPONENT <---I
INVENTORY +
times. I
I
PRODUCTION <-----I
SCHEDULE I
SIMULATION OF AN INTERNATIONAL n I
I
SUPPLY CHAIN I I
SYSTEM --->
I I
The supply chain as a complex dynamic system COMPARE ACTUAL !
INVENTORY VS. TARGET INV. i
A I
The simulation of an international supply chain I
I
I
demonstrates how chaos theory can be applied !
to the understanding of a real managerial issue. TARGET SYSTEM INV.
n
i
i
The example is drawn from the author’s research
I I
into the costs of coordinating the international
supply chain of a personal computer company
called California Computer Technology (CCT).4
pq -----> SALES FORECAST ---3
I
Following Eisenhardt (1989), a case approach Figure 1. A Model of CCT’s supply chain
was used to build and test theory in an iterative
manner.
The research led to a conceptualization of the capture the essence of the supply chain. Materials
supply chain as a complex, dynamic, nonlinear move along the chain in one direction, gaining
system. The system is subject to external disrup- value at each stage. Information is exchanged in
tions, and the stages of the chain are linked by both directions among the organizations along
flows of goods and information, with time lags the chain. This simple representation is very
and feedback mechanisms. The complexity of useful in analyzing the potential sources of
interactions along the supply chain is such that coordination costs in a supply chain and the
one cannot easily-predict how the system will impact of geographically separating stages of the
operate under various conditions, but a computer chain. It is also valuable as a tool for designing
model of these processes can simulate the strategies that improve the performance of a
outcome (Lant and Mezias, 1990; Morecroft supply chain.
1984). Figure 1 is a simplified representation of There are two important dimensions to this
CCT’s supply chain, showing in schematic form system, uncertainty and time relationships.
the flows of goods and information within the Rather than performing as a stable, ready state
model. Solid lines represent flows of goods, system, each stage of the chain is potentially
dotted lines flows of information. subject to disruptions, or ‘shocks.’ Demand
In reality, supply chains are often much more fluctuates in an unpredictable way, production
complex than this. CCT, for example, has problems can affect output, and suppliers do not
hundreds of vendors, three production sites, and always deliver on time. When demand and
distributors and warehouses in many countries. production are rising, delivery and production
Corporate headquarter functions interact with problems are more likely. As a result of the
vendors, the field sales organization, and the uncertainty at each stage, flows of materials
production sites. Nevertheless, the diagram does and finished systems fluctuate in volume, and
inventories need to be adjusted to cope with the
JThe name of the company has been disguised to protect uncertainty. The linkages themselves are also
proprietary information. subject to disruption. Shipments and communi-
174 D.Levy
cation can be delayed, and information can be INVENTORY TO DEMAND RATIO FOR 100 MONTHS
misunderstood.
A second important dimension of the supply
chain system is the time relationship among
the stages. As a result of the time lags in
communication, production, and distribution, a
disruption to one element generates a sequence
of changes in other parts of the system. For
example, demand fluctuations cause changes in
sales forecasts, production schedules, and order
to vendors. Disruptions originating in any one
part of the system, in effect, propagate forwards
and backwards along the chain. Disruptions can -1 '
60
interact; for example, a production problem 1
TIME (MONTHS)
100
I 0.09
j 001
g 0.08
U
z 0.05
g 0.04
2
Y
003
:
002
-0.8
-0.8 ' I
& I
I
50 O'Ol 0.1 0.2
1 100
TIME (MONTHS) STD. DEV. OF MONTHLY % CHANGE IN DEMAND
Figure 3. Simulated inventory levels, product made Figure 4. Impact of demand stability on unfulfilled
and sold in U.S. demands