As the recent financial crisis has showed so dramatically, networks exist everywhere. Global inter-linkage of loans and mortgages — which were intended to distribute risk — actually ended up spreading it far and wide. Similar network-based impacts are at work in fields as diverse as information security and supply chain management. But while networks create new risks, they also generate new opportunities, write Paul R. Kleindorfer, Yoram (Jerry) Wind and Robert E. Gunther in their new book, The Network Challenge: Strategy, Profit and Risk in an Interlinked World (Wharton School Publishing). In an interview with Knowledge at Wharton, Kleindorfer and Wind discuss the themes of many of the 28 essays in their book.

An edited transcript of the conversation appears below:

Knowledge at Wharton: Paul and Jerry, thank you so much for joining us. I wanted to talk to you about The Network Challenge: Strategy, Profit and Risk in an Interlinked World. Could you tell us a little bit about why such a book is needed at this time? Why are networks so important and what kinds of challenges and opportunities do they create for business enterprises?

Paul Kleindorfer: The systemic issues that have become very apparent in the financial crisis that we’re a part of now [are] one indicator of the reason why network-based strategies on the profit and risk side are becoming crucial. There are also very interesting developments on the political and institutional side that are perhaps captured best in the current debate about climate change — the Waxman bill that was reported out in Congress, [for example]. [The Waxman-Markey bill, the American Clean Energy and Security Act, was reported out of the House Committee on Energy and Commerce in the U.S. House of Representatives on January 24, 2009, and referred to the full legislative body for debate.] Various elements of the U.S. [economy are] interlinked with China, India and the rest of the world and certainly Europe in the carbon-based economy. And there are big debates about where that is going.

All of this suggests that companies are, more than ever, linked to the profitability, viability, health and resilience of the networks that they’re a part of. And [they] no longer should, nor can, ignore these network affects in their strategy, in their assessment of where opportunities lie for markets or where risks or threats lie.

Jerry Wind: Let me add that in addition to these, we have to look at some fundamental shifts that are happening in society. Central to them are the dynamics of the consumer. Consumers are becoming much more empowered, and in recent years — especially as a result of the crisis — you see lack of trust and confidence in institutions. Consumers tend to rely more and more on themselves. [This is] part of the explanation for the enormous growth in social networking. At the same time, increasingly because of the interdependency around the world that started [with] outsourcing and the like, you have a huge need for corporations to start moving beyond thinking just of the corporation by itself, but [to think instead of] the corporation and its partners as part of a supply chain and moving much more into realizing the importance of managing a network of companies. That’s really part of the motivation.

We see the phenomenon out there. How do we address it? How do we identify the opportunities, the risks? How [do we] manage them more effectively? What are the implications? And the reason for the timeliness of this book is that networks [are] not a new phenomenon and [have] been addressed by many, many disciplines over the years. This is the first effort — at least that I’m aware of — to bring together the experts from a diverse set of disciplines in one place to explore what we know about their studies, their research, their experience with networks, and what we can learn from this that will help us manage better networks and address the risks and opportunities embedded in them.

Knowledge at Wharton: That’s a great point. I know, for example, that your book draws upon the growing body of research on network phenomena in all kinds of fields — not just in business, but also in fields like biology, infectious diseases and so on. Could you explain how you see the connection between these areas?

Kleindorfer: There are interesting connections at several levels. First, the fundamental change in moving from a firm-centric strategy or perspective to a net-centric perspective is one that recognizes the additional complexity associated with networks that is really not a part of the firm-centric perspective of strategy. And that complexity is very important in terms of the consequences for whether one views a company as master of its destiny and able to determine exactly what the rules of play are going to be, or whether it views itself as a part of a pulsating organic system of multiple partners, as Jerry was just explaining in his comments. The one leads you to a view of a kind of a single hero on a white stallion, and the other leads you to a view of, let’s say, a worthy group of noble participants moving together but hopefully coordinated and knowledgeable about the other participants on the field of play. So the first thing is the complexity issue.

The second thing that we derived that is really important — from, for example, artificial intelligence, biology, some of the work on social networks — are the unexpected emerging structures that come out of these fields that both provide some sense of humility that we must have about our current understanding and ability to control networks, but also represent in some ways the increasing imperative to have peripheral vision, to scan, and to look for opportunities that might emerge from these dynamic evolutionary structures that you just really wouldn’t look for if you were taking the typical, or the old fashioned, firm-centric [view that] everything happens at corporate headquarters. So we really do learn an awful lot from them.

I would just add the one additional point that it really was a huge source of satisfaction to Jerry and me in looking at this book to see the interplay [between] business and economic activities and the points of intersection with some of the natural sciences and some of the artificial intelligence work, in the sense that when you really view the agents in the system — which you must in economics and business terms — as purposeful, as profit-oriented (let’s just say as pursuing their own particular objectives at the nodes of these networks) it begins to add a certain new sense, a new set of directions to the kinds of models and interpretations that one might entertain about biology or about some of the other systems we looked at. There were some interesting points of intersection and light that materialized back the other way as well.

Knowledge at Wharton: Thank you, Paul. Jerry, you point out in the book that there are perils that companies face by neglecting network affects. One example you give in the book is the current financial crisis. Could you explain that please?

Wind: A lot of what we have seen recently in the current financial crisis is the speed at which things happen and the magnitude of this. This is primarily the result of the interconnected world. There is no economy that is basically protected from this, whereas we may have different countries [in which] the crisis started differently. In the U.S., it started with the housing and the subprime problem that moved to the financial institutions and then moved to the real economy. In other countries it may have started with the financial sector. Some of the Swiss banks, for example, basically just bought the U.S. sub[prime] mortgages and the like.

But primarily it is the interdependencies — around the world — of all the financial institutions that led to this incredible, very fast and steep reaction. So I think you see it there. It’s something that we definitely have to learn from. While there is a lot to learn from the previous financial crisis — whether it is the Japanese crisis or even going back to The Great Depression — the conditions have changed. It is because of technology, because of the speed of communication today. The speed of interactions among the various parties involved in any activity today is so much greater and so much bigger and faster, and the reason we see such a big crisis.

Kleindorfer: Jerry, if I could just add two additional points to the perils dimension of that, I would point to the papers in this volume on pandemics or infectious diseases, and the spread thereof through networks — [including]… the papers on East Africa on AIDS, both on the positive and negative side with respect to that — and then the very interesting paper by Boaz Ganor on terrorism networks. All of these really indicate (together with the more positive notions about peripheral scanning and so on that are a part of the book) that networks are with us and are affecting us both in business and elsewhere in ways that were simply not a part of the picture when there were fewer people on the planet, lower interactions in terms of communications and economic interactions, and a whole lot lower in terms of the travel interconnections.

You put all of that together on the board, and if you’re a life insurance company and you weren’t frightened by the prospect of the consequences of a pandemic breaking out, you probably need to read this book and understand a little bit more about kind of the modeling and the realities of the interdependencies that Jerry has indicated on the peril side. So those are just three examples from the book that I think are equally important in terms of the interconnected and interdependency issues.

Knowledge at Wharton: Absolutely. I’m sure that people will find those lessons very illuminating. Now to move away from the risk issue to opportunities, you also point out that this book is not just a passive academic summary but is intended to transform the way that businesses use, build and profit from networks. So what would be some positive opportunities that businesses could derive by harnessing networks to create value and to identify new opportunities?

Wind: Let me start with a few examples and then Paul can add some. Let’s look at the whole area of supply chain and the concept that we proposed of network orchestration, which primarily came from the work of Li & Fung. [Li & Fung Ltd., founded in China in 190 and currently headquartered in Hong Kong, is known as a particularly deft global supply chain manager.] How do you leverage resources and expertise around the world, which are not only necessarily cheaper but also in many cases better quality? So there are new opportunities in terms of looking at the entire world as their arena of operations, orchestrating a network of companies that can help you deliver the offering — the benefit — that you want. In this respect, the traditional firm-centric view of management that talks about core competence of the firm is really being replaced by the fact that you don’t necessarily need all these competencies. You need to be able to connect to the right competencies around the world.

The new competencies for the firm are primarily in the area of ability to connect competence for innovation, and competence for learning, which is a different set of competencies one looks at. You can also look in terms of what happened in the latest presidential election and how President Obama so effectively used the network primarily to try to win the election. His is basically the political kind of science, if you want, or the political reality that he instituted is now being viewed as the model by most companies who are trying to imitate this and say, “How do we leverage the networks out there?” So there are tons of examples in almost every one of the chapters in the book. There is an effort to identify also some of the opportunities that are involved in our network thinking.

Kleindorfer: Yes. I would add just a couple of things to that array of interesting notions. First, of course, Jerry was too modest to mention this himself, but his chapter with the two Fung brothers really is a wonderful example of a network based company. Increasingly we are seeing companies in the pharmaceutical industry, certainly the textile industry, and generally in knowledge-based or advertising-related industries (Google and so forth) that have gotten clear religion about the network-based model of the firm and see business models that are in some ways automatic or promoted by their own dynamism. The key is to enable, not to control, to allow emerging profit structures to come forth rather than try to dictate. Those kinds of changes in attitude and view are represented throughout the book.

I’ll just mention two other areas that I’ve seen now increasingly in several discussions over the past year since we this book went into press. In the health arena, there are some deep specialties, from hygiene to nutrition to wellbeing to the insurance part of it to the health care provision part. Putting those together in an effective way, focused on a particular patient (client, person, consumer), is a network-based phenomenon. The paper by C.K. Prahalad in the book makes pretty clear some of the promise in that direction and not just for developed countries, but also developing countries. I’ve seen that same thing touted increasingly for various other health applications just in the past year.

Then the second area is the work in innovation — both internal innovation (there are several papers on internal innovation that are not just about the 24/7 pockets of innovation going across the planet … but also external — the idea of having social networks and others that are empowered by consumers, especially the younger generation. They are simply flying. They are off at the speed of light; perhaps I should call it “warp speed”. But, in any case, they are definitely far in excess in terms of the ideas generated, far in excess of the very low level of speed of generation of ideas and accumulation [belonging] to the traditional model.

Wind: Let me try to add two quick things on this last point because I think it’s very important. Every company recognizes the centrality of the consumer and that you have to start designing strategy by understanding the evolving needs of your target consumers and the like. The reality is that many companies are talking about this, but not doing it. Yet the emergence of networks of consumers and the increased importance of social networking in life in general leads to a new way — and opportunity, really — to capitalize [on] and truly implement a customer-centric strategy where you realize that you have empowered consumers and they are part of your network.

One of the major challenges facing companies is that the more you move into the network area and you start orchestrating a network, [the more] you realize you don’t have the control (the traditional control) that you had. And that’s probably one of the biggest challenges facing management. How do I achieve my objective in a network world when I don’t have the control I used to have in the old world, a firm-centric world? This consumer involvement is part of open innovation, but open innovation is actually even broader than this. You have companies such as P&G that are trying to have over 50% of their new product and service offering come from outside the firm. You have companies such as InnoCentive, which is basically the eBay of innovations, that is a network of 170,000 experts who are ready to solve problems that any company has and basically link their network of experts with companies that seek advice. So there are tons of developments in this area. Hopefully management all over the world will start understanding them and try to redesign their strategies to capitalize on these opportunities and avoid the risks involved in networks.

Knowledge at Wharton: Thank you, Jerry. Paul, another interesting paper I found in the book is the one by Colin Crook examining network affects against a background of complexity theory. Could you explain that a little bit please?

Kleindorfer: The complexity issues that Colin and others have studied over the past decade or so arise in part from the field of artificial intelligence, in which fairly simple rules and competencies attached to nodes, when they interact with other nodes, give rise to fairly interesting systemic or macro affects. You can just think of cars or people or artificial agents bumping into one another and then moving off in particular directions to suit their needs. Depending on what it is that they’re equipped to do (how far they can see one from another into the distance and what their particular motives are in terms of accumulation or consumption), these artificial networks have really shown very interesting complexity affects in terms of the ability to show when groups of such artificial agents run off a cliff and end up in a disastrous place, or when they end up nourishing one another — things of that sort.

Colin is a real master of that and he has years of experience watching people run off cliffs. He was the chief technology officer at Citibank for a number of years. So we won’t blame him [for] the current crisis. But he watched a number of those exercises occur and he was really inspired by that to comment on the emerging science of complexity theory which attempts to sort out exactly what elements of networks — their connectedness or the lack of acuity or visibility of agents in them — what sorts of things lead to risks and what sorts of things lead to benefit.

One example is the current financial crisis. The question that is being posed very actively there is, “What level of regulation and what sort of regulation should be required in order to have the benefits of innovation from new financial instruments such as those we’ve seen actually help a lot in the insurance area? How do you get the benefits of that innovation without having such highly leveraged activities or activities that have the maturity of liability in assets so much out of whack that they’re not able to survive shocks? How do you get that balancing act done? What level of regulation should be put into place to, if you will, assure the network affects, if they’re there, are not so severe, that shocks don’t turn the system over?” And, of course, all of that is about how one gets sufficient visibility from the firms that are a part of this, from their balance sheets and their asset positions, to actually evaluate the risks that they’re confronting. And if you do that using the old fashioned firm-centric VAR measures, value at risk measures, which stood us in good stead for a long time, you simply cannot get the job done. So what new measures have to be put into place?

I tell you that complexity theory (and the whole issue of just how much by way of assets and capital adequacy or solvency needs to be in place given the mix of the effective network interdependencies that are a part of these instruments or implied by them) is center stage in the current debate on regulation and re-regulation of the financial sector. So that’s an example where, I think, what Colin has to say both in terms of having humility about what we know about these matters but also about the fact that network contagion and emerging structural affects of networks simply cannot be dealt with by looking at one individual or a single individual nodes. You really have to accommodate them at the network level.

Knowledge at Wharton: That’s great. To take just one final question. Jerry, I wonder, based on everything that you and Paul have said, how can organizations redesign themselves and change their approach to lead in a networked world?

Wind: It’s a great question. That’s really the challenge. I think, first of all, hopefully they have to challenge their current mental models. Because most firms — there are obviously exceptions: P&G is becoming more of a network organization because of the open innovation; Li and Fung is set to evolve as a network company, but with few exceptions — most companies, their management, their structure, their thinking is very firm-centric. So that’s a challenge to the mental model of the firm-centric versus the network one. Both Paul and I hope very much, that the book will help people challenge this mental model by bringing in concepts and findings as well as methods from diverse fields and suggesting some specific areas for publication. I think this will help in this area.

Now having challenged the mental model, so what do I do next? [If] I buy your argument and I believe that network thinking is what we need, then my suggestion: At least identify those areas that will allow you to leverage your current resources and expertise, moving from a firm-centric to a network-centric [approach]. In my view, this is typically in the areas of establishing consumer networks, leveraging them in terms of getting consumers, schools of designers, schools of producers, core marketers to consumers as advocates and promoters of your product and services. The other major area would be in the open innovation area. But let a firm identify the big opportunities they face and try to identify and design an experiment of doing it.

I’ll give you a quick example of a company doing it right now that developed a very large technology platform internally. The projection, if you look at development, [is that it] will take them another four years to try to fully develop it to be able to go to market. It’s crazy in today’s environment to wait another four years after they have been already five years in development of a pharmaceutical product. So they are moving now into an open architecture and creating a social network of their employees in other divisions, customers, and developers to join and basically understand the platform and start developing products and services on the platform. So I think companies should engage in these experiments. And assuming the experiments, hopefully, will work, they will learn from this and be able then to move and expand [the process] further into the firm.