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New models help executives learn to fly

AUTHOR: Lachlan Colquhoun   DATE: 01.05.05   ISSUE 1, 2005

Instead of learning how to land a 747 at a virtual airport, however, executives are using these simulation models to understand the dynamics of their business, and to experiment with different strategies to see the outcomes.

Erik Larsen, who is Professor of Management and Systems at the City of London’s Cass Business School, spent some time at AGSM recently developing his models, with a focus on the electricity markets.

Professor Larsen’s method is to use the combined experience and insight of a group of managers, and create dynamic models where users test their hypotheses about the impact of various strategy decisions on the business, competitors and customers.

Professor Larsen creates dynamic models where users test their hypotheses about the impact of various strategy decisions on the business, competitors and customers.

Using a well-established modelling approach called system dynamics, developed in the 1960s at the Massachusetts Institute of Technology, Professor Larsen has developed sophisticated computer models which, when connected with a user friendly interface, allow executives to participate in “virtual” energy markets.

System Dynamics was originally used for inventory control and other operational management decision-making, but the arrival of user-friendly software packages moved it onto the desktop of personal computers, and made it accessible to a wider base of users and for a variety of applications.

Professor Larsen’s method is to use the combined experience and insight of a group of managers, and create dynamic models where users are able to test their hypotheses about the impact of various strategy decisions on the business, competitors, and customers.

“System dynamics is a way of understanding the world from a holistic or helicopter view it factors in feedback from stakeholders and connections between all the relevant factors which produce an outcome."

“These models are all about learning, but nothing about making predictions, and that is the big difference with other computer models,” Professor Larsen says.

“System dynamics is a way of understanding the world from a holistic or helicopter view, and it factors in feedback from stakeholders and connections between all the relevant factors which produce an outcome.

“Using these models we try and find causal explanations, where we can say that A leads to B and C leads to D, or how does A impact on B.”

Executives use simulation models to better understand their business and experiment with different strategies.

ILLUSTRATION: Gregory Baldwin

Much of Professor Larsen’s model development has focussed on the electricity markets, which has become a popular field for the application of system dynamics.

Professor Larsen says the power markets is a fertile area because the global power industry has had to respond to the shock of de-regulation, which has transformed the entire competitive landscape beyond recognition.

System dynamics is also well suited as an approach to modelling the power industry.

A study of the Californian energy crisis, completed using principles of system dynamics, demonstrated how a deregulated power market could be influenced by construction cycles which could have a profound effect on margins, and retail prices.

System dynamics is also well suited to modelling the power industry.

This study has since informed much of the thinking on the industry, which has undergone radical and rapid change.

When monopolies ruled the industry, until quite recently, the only planning utilities needed to do was for capacity.

Now, power companies cannot necessarily expect to make any return on their capacity investments, a dilemna which demands a much more rigorous and sophisticated planning process.

“Think about it as if you were born as a 30 year-old – you are grown up but you know nothing about the world you find yourself in,” says Professor Larsen.

“Previously you were a monopoly and you controlled everything – if you weren’t making enough money you just put up the price, and because there were no competitors the customers had absolutely no choice.

“But now, there are competitors, there are regulators and Governments which used to be your friend, but which could now be in a more confrontational relationship, and you have customers who – if they don’t like you – can go somewhere else.”

System Dynamics Models Professor Larsen has developed system dynamics models – or games as he calls them – for power companies in several different markets, from Europe to South America. They come in two forms – games with a pure teaching function, designed for students, and games developed for specific corporates, who want to understand more about their options in the competitive environments they face. While the power industry has been a major focus, he is in the process of doing the same for a major hospital along the same principles. A teaching model took the example of a restaurant chain, where users were able to open new restaurants, choose locations, hire staff, and develop the brand. Sitting down with managers from various parts of the business, Larsen builds these simulation models not with the intention of producing forecasts of what might happen in the future, but to enhance learning. The collaborative approach to model building factors in as much information as possible, and produces insight “into the whole system.” “These models don’t give you final answers – they provide an opportunity to see, and to develop and re-shape your assumptions,” he says. “If people discover things for themselves it is a much more powerful way to learn, and these models have been very well received.”