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1 Working Paper Series No. 20 A Capability Theory of the Firm: An Economics and (Strategic) Management Perspective David J. Teece 1 24 April 2017 1 Thomas Tusher Professor of Global Business & Director, Tusher Center on Intellectual Capital, Haas School of Business,, University of California, Berkeley; Chairman; Berkeley Research Group, LLC. Email: [email protected].

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WorkingPaperSeriesNo.20

ACapabilityTheoryoftheFirm:AnEconomicsand(Strategic)ManagementPerspective

DavidJ.Teece1

24April2017

1ThomasTusherProfessorofGlobalBusiness&Director,TusherCenteronIntellectualCapital,HaasSchoolofBusiness,,UniversityofCalifornia,Berkeley;Chairman;BerkeleyResearchGroup,LLC.Email:[email protected].

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Abstract

Thebusinessenterpriseistheprimeinstitutionineconomicdevelopmentandgrowth;yet,untilrecently,mainstreameconomicshasmostlytreatedfirmsashomogeneousandthereforeinterchangeableblackboxesmanagedbyuntrustworthy,opportunisticagents.Usingeconomicprinciples,thefieldofstrategicmanagementhasdevelopedanuancedapproachtotheunderstandingofhowfirmsarecreated,organized,andgrow,howtheyinnovateandcompete,andhowmanagersmanage.Thatapproachhasyieldedatheoreticalframeworkknownas“dynamiccapabilities.”Contrastsaredrawnbetweendynamiccapabilitiesandotherapproachestothetheoryofthefirm,includingtransactioncosteconomicsandagencytheory.Dynamiccapabilities,andcapabilitytheorymoregenerally,abandonthehomogeneityassumptionofmicroeconomictheory.Thisallowsintellectualblinderstoberemovedandanunderstandingofdifferentialfirm-levelperformancetoemerge.Capabilitytheoryrecognizesthatfirmsoftenhavecapabilitygapsthatneedtoberemediedtobuildlong-termcompetitiveadvantage.Aricherconceptualunderstandingofthenatureofthebusinessenterpriseanditsmanagementconsistentwithevolutionaryandbehavioraleconomicsariseswhencapabilitiesarecenterstage.Policyinsightsintogovernance,inequality,economicdevelopment,andthewealthofnationsfollow.

Keywords:firmheterogeneity;dynamiccapabilities;transactioncosttheory;agencytheory;x-inefficiency;d-ineffectiveness;strategy;entrepreneurship;evolutionaryeconomics;uncertainty;inequality.

JELclassifications:B52,D21,L23

Acknowledgments:TheauthorismostgratefulforcommentsandexchangeswithGaryPisanoandDavidJohnston,particularlywithrespecttocapabilityaugmentation.OthercolleaguesincludingGiovanniDosi,ConnieHelfat,NeilKay,RichardNelson,OliverWilliamson,andSidneyWinterhavehelpedguidemythinking.GregLindenprovidedhelpfulideasandassistance.

**Correspondence:D.J.Teece,BerkeleyResearchGroup,2200PowellStreet,Suite1200,Emeryville,CA94608,USA.E-mail:[email protected]

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1.IntroductionThepursuitofprofitiscoretocapitalism,asistheinnovationthattakesplaceinthebusinessenterprise.Theyarecoretocreatingvaluethatis,inturn,sharedbetweensocietyandthevariousstakeholders(includingbothshareholdersandemployees)associatedwiththeenterprise.

Somefirmsprovetobefarmorecompetitivethanothers.Whilethisfactwillbeself-evidenttomostobservers,economictheoryhassurprisinglylittletosayaboutwhythismightbeso.

Economistscannolongerclaimtoanalyzecertainmajoreconomicissueswhilerelyingonblack-boxmodelsofthefirm.Agrowingbodyofempiricalresearchonincomeinequality,forexample,hasestablishedthatanunderstandingoffirm-leveldifferencesiscriticalbecausewagedifferencesarelargerbetweencompaniesthanwithinthem(e.g.,Barthetal.,2016;Abowd,McKinneyandZhao,2017).Songetal.(2016)foundthatovertwo-thirdsoftheincreaseinearningsinequalityfrom1981-2013canbeaccountedforbytherisingvarianceofearningsbetweenfirmsandonlyone-thirdwithinfirms.Oneoftheco-authorsofthatstudynotedinaseparatearticle(Bloom,2017)thatinterfirminequalityhasbecomegreaterandmorepersistentasfirmsincreasinglysortthemselvesintoasmallnumberofknowledge-intensivecompaniesandalargerpoolofrelativelylabor-intensivefirms.Moreover,evidencesuggeststhatinterfirmdifferencesinprofitabilityarebecomingmorepersistent(FurmanandOrszag,2015).

Understandinghowsomeenterprisesbuildcapabilities,grow,andcreatecompetitiveadvantage,leadingtohigherprofits(andhigherwages)aboveaperfectlycompetitivelevel,isanessentialelementforunderstandingcapitalismandthemoderneconomy.Indeed,asJohnSuttonoftheLondonSchoolofEconomicsstatesinhisrecentbookCompetinginCapabilities:“Theproximatecause[ofdifferencesin

thewealthofnations]lies,forthemostpart,inthecapabilitiesoffirms”(Sutton,2012:8).

However,despitethesalienceofcapabilitiestobusinessperformanceandtoeconomicperformancemoregenerally,economists,untilquiterecently,havenotdevelopedtheconcept.AboutallthateconomistssinceAlfredMarshallhavetoofferwithrespecttothesourcesoffirm-levelcompetitiveadvantagearetheoriesofmonopolyandimperfectcompetition.Unfortunately,theoriesofmonopoly,oligopoly,andotherformsofimperfectcompetitionineconomicsareratherbarrenwhenitcomestoexplaininghowinnovativefirmslikeAmazonandAppleoutcompeteotherinnovativefirmslikeNokiaandMotorola,whySingaporeAirlinesandEmiratesAirwayshavecometobemajorcarriersthatcanprovidesuperiorservicewhilegeneratingattractiveprofits,andwhyFonterraneeds“tobefarmoreagile”andstrugglestoaddsignificantvalueforitsdairyfarmerowners(Fox,2015).Perhapsthereasonisthatthereisnotheoryofcapabilitiesineconomics.

Surelyoneofthemostimportantquestionsinbotheconomictheoryandeconomicrealityishowindividualfirmsbuildandmanagecapabilitiestocreateandcapturevaluesoastoavoidthezero-profittrapofcompetitiveequilibrium.Sadlythough,thisisnotwheremoderntheoryhasgone.Theassumptionofhomogeneity(ornearhomogeneity)offirmshassuffocatedthisinquiry.Partofthecollateraldamageisthatthefieldofeconomicsisbereftofappreciativeframeworksthatcanprovideusefuladvicetofirmsmakingresourceallocationdecisionsortopolicymakersendeavoringtounderstandfirmsandshapebetteroutcomesforsociety.

Nevertheless,theRoyalSwedishAcademyofScienceshasselectedseveralLaureatesinEconomicsinrecognitionofworkonefficiency-basedtheoriesofthefirm.Efficiency-basedeconomicmodelsoutlinearrangementsthat,inpractice,arerelativelyeasytoimitateandthatthereforecannotsupportdurable

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firm-specificperformanceadvantageseventhoughtheymightaidproductivity.Thus,notwithstandingNobelprizestoCoase,Williamson,andHartfortheirimportantworkonhowfirmsorganizetheiractivities,manyfundamentalquestionsaboutfirmshavebeenleftunanswered,suchashowtheycreatevalueandprotectthatvaluesoastogrowandhavedurablecompetitiveadvantagedomesticallyandglobally.Thebuildingandmaintenanceofcompetitiveadvantage,totheextentitisderivedfrominnovationratherthanfromsometypeofmarketrestriction,isarguablymoreseminalthananinquiryinto(static)efficiencybecauseitfocusesonhowfirmsdevelop,learn,and,insomecases,become“great”andbenefittheirstakeholders,ratherthanmerelyselectboundariesorgovernancestructuressoastobecomeefficientenoughtojuststayalive.Theapparatusofproduction,transactioncosts,andagencytheorysimplydoesnotaddressthecriticalquestionsthatmanagers,asresourceallocators(andstewardstomultiplestakeholders),strugglewitheveryday.Despiteimportantadvances,mainstreammicroeconomicstellsusnexttonothingaboutthedynamicallocationofresources,themaintenanceofdifficult-to-imitatepositivedifferentiation,andthesourcesoffirm-levelgrowthinemploymentandprofits.ToheterodoxeconomistslikeDosi,Nelson,Winter,andmyself,thisisanembarrassinglacunaineconomictheory;butitdoesnotseemtoperturbthemainstream.

Asnoted,themonopoly"problem"—withitsfocusonwelfareloss—isoneofafewplacesineconomictheorywheresingle-firmissueshavebeenaddressed;buttheanswerssofarareoflimitedvalue.Whilescale,scope,networkeffects,lock-in,andproductdifferentiation

2TeeceandColeman(1998)discussthreesourcesofeconomicrents:Ricardian(scarcity)rentsaccruetothefirmforitscontroloverscarceandvaluableinputs;Schumpeterian(entrepreneurial)rentsaccruetoafirmforitsabilitytoexploituniqueknowledgeassetsintheperiodbeforerivalsareabletoimitateitsproductsorservices;and

areallpartofthemoderntoolkitthateconomistsreachintoforexplanationsofmarketpower,thesefactorsdonotgonearlyfarenoughwhenitcomestounderstandinghowindividualfirmsestablishandmaintaincompetitiveadvantage.Indeed,theprofessionhasbeenslowtoexplainwhyeventhesestructuralfactorscanproveinadequate,andhowevenasmalldegreeof“monopoly”powercanbecontestedbydisruptiveinnovators.Marketandorganizationalevolutionarealsoexpresslyneglected.

Asnoted,someprogresshasbeenmade.However,intextbooktheory,thereislittleefforttolookatparticularfirms,orgroupoffirms,theirhistories,andorganizationalandtechnologicalissuesinasystematic,time-sensitivemanner.Thecontinuedsilenceofmainstreameconomistsonthesematterscontributestopolicymakershavingjaundicedandnaïveviewsoftheroleofmanagersandofthebusinessenterpriseintheeconomyandinsociety.Studentscomplainbitterly,whilefacultiespushback.

Inshort,despitetheeffortsofMichaelPorterandothers,standardmonopolytheoryistoobluntaninstrumenttosupportameaningfulexplanationofthedifferentialfinancialperformanceoffirmsindynamicallychangingmarketslacedwithdeepuncertainty.2Amoregranularviewofhowwealthiscreatedandcapturedbyfirmsisneeded.Anewviewmusthave,atitscore,atheoryofcapabilities.Suchatheorymustexplainwhattheyare,howtheyarebuilt,howtheyareemployed,andhowvalueiscaptured.

Theneglectof(single)firm-levelissuesbythemainstreammicro-theoristshasleftthedoorwideopenforstrategicmanagementscholarstoaddress

Monopoly(Porterian)rentscanarisefrom“exclusionaryconductlackingefficiencyjustifications,frompredatoryconduct,orfromgovernmentallyconferredprivileges(e.g.,licenses)”(TeeceandColeman,1998:822).Onlymonopolyrentsshouldbeofconcerntoantitrustregulators.

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importanteconomicissuessuchashowsuccessfulfirmscreatedifficult-to-imitatecapabilitiesandotherpointsoftechnologicalandorganizationaldifferencethatenablethemtoinnovateandtoallocateresourcesbetterovertime.Suchanexplanationhasfailedtoemergeoutofstandardeconomicmodels.NotevenmodernCoase-WilliamsonandHart-Mooretheoriesofthefirmareuptothetask,perhapsbecausetheyassumethatmarketsaremorecompletethantheyare.WhileWilliamsonisexplicitthatcompletecontingentclaimsmarketsdon’texist,heandothers,includingCoase,goontoassumethatmanypricesexistwhen,inreality,theyoftendonot(BoudreauxandHolcombe,1989).Marketsaremoreoftenincomplete(Arrow,1962,2012),propertyrightsareoftenindispute,innovationregularlythrowstheeconomicsystemintodisequilibrium,andKnightianuncertaintyisubiquitous.

AsNelson(1981)explains,theveryessenceofcapitalism—infact,theveryadvantageofaprivateenterpriseeconomyoveraplannedone—isthat,withprivateenterprise,firmsinnovate,compete,sometimesdisrupteachother,andsometimescooperate.Thisobservationwouldsuggestthattheabilityofacapitalisticsystemtoinnovate,morethanthetwintheoremsofwelfareeconomics,oughttobethelynchpinofourunderstandingoftheadvantagesofmarketeconomies.Yetthisisnotthecase.Moreover,thefieldofindustrialorganization,whichclaimstoanalyzecompetitionissues,hasnotfullyfaceduptotheimplicationsofworkingwithinamarketstructure-performanceparadigmthatsaysalmostnothingaboutthenatureoffirms’capabilitiesorabouthowinnovativefirmsandmarketsevolve.

Inthispaper,Iendeavortoaddresstheselacunaebydevelopingaframeworkormeta-theoryoffirmcapabilitiesandinparticular,atheoryofhowfirmsinnovateandchangesoastomaintainevolutionaryfitness.Anunderstandingofcapabilitiescanhelpeconomistsbegintofillinimportantgaps.Thebasicargumentisthatfirmsdifferentiatethemselves

throughlearning,entrepreneurship,innovation,andastutedecisionmaking;inshort,firmsaredifferentiatedbytheircapabilities,especiallytheircapabilitiestodecide,toinnovate,andtochange.

Thepaperstartswithananalysisoftheshortcomingsofthedominantmicroeconomictheoryofthefirm,notingtheadmonitionsofCoase,Romer,Leontiefandotherstobeloyaltothephenomenaathandandnotmerelyaccepttheoreticaleleganceandtheacclaimofcolleaguesasindicatorsofgoodscience.Ithenintroducethecapabilitiesviewofthefirm.ConceptssimilartowhatIcall“ordinarycapabilities”arebeginningtogainrecognitionamongeconomists.Thedynamiccapabilitiesframework,whichencompassesthefirm’sabilitytoactinanentrepreneurialfashion,hasalsogainedsomeattention,buthasyettobefullyintegratedintoeconomictheory.Thepaperthencomparesthecapabilitiesframeworkwithmainstreameconomicmodelsinanumberofareas,includingmarketsandtheboundariesofthefirm.Specialattentionisgiventothecontrastingwaymanagersaretreatedintheeconomicsandcapabilitiesframeworks.Next,afewareasareidentifiedwhereacapabilitiesframeworkcouldbeusedtobetterinformpolicy,includingantitrust,corporategovernance,andeconomicdevelopment.Afinalsectionsummarizesandconcludes.

2.FundamentalLacunaeintheTheoryoftheFirm

ThetheoryofthefirmhasreceivedconsiderableattentionsinceRonaldCoase’sfamous1937article“TheNatureoftheFirm.”Economistshavecertainlybeguntograpplewithquestionssuchas(1)whyfirmsexistinamarketeconomy;(ii)whatdeterminestheboundariesofthefirm;(iii)howfirmsshouldbeorganizedtoalignincentivesformanagersandownersand(iv)howtheyshouldbestructuredfinanciallyto

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maximizeprofitsandminimizemanagerialmalfeasance.EconomistssuchasCoaseandWilliamsonhavehelpedmassivelyonthefirstquestion.WilliamsonandKlein,Crawford,andAlchianhavecontributedonthesecond,ashaveI.ApanoplyofeconomistsincludingJensenandMecklingandAlchianandDemsetzhaveputeffortintothethird,whileJensenandothershavecontributedsignificantlytothefourth.However,asHaroldDemsetznoted:“Neoclassicaltheory’sobjectiveistounderstandprice-guided,notmanagement-guided,resourceallocation”(Demsetz,1997:426).Thisfocusisamajorlimitationasitdeflectsattentionfromcriticalresourceallocationdecisions.

Inparticular,economistshavebeensilentfortoolongoncriticalmanagerialissuessuchas:(i)howfirmsinnovate(beyondjustspendingmoneyonR&D);(ii)whyfirmshavecapabilitiesthattranscendthesumofindividualskillsoftheiremployeesandcontractors;(iii)howindividualfirmsevolvesoastobuildandsustaincompetitiveadvantageoverrivals.Asalreadynoted,thethirdissueisarguablymorefundamentalthaneither(i)or(ii),andalsomanyoftheotherquestionstowhichtheprofessionhasalreadygivenitsattention.

Thethirdquestionhasimplicationsforthestakeholdersofthefirm(employees,shareholders,customers,suppliers)andistalkedabouteverydayinthebusinesspress.Ithas,toaninadequateextent,beenaddressedinthestudyofmonopolyandimperfectcompetition.Economistsusuallyappealtosomekindofstructuralcausesuchasentrybarriersorscaleandscopeeconomiestoexplainwhysomefirmsgetahead.Morerecently,first-moveradvantage,networkeffects,multi-sidedplatforms,andswitchingcostshavebeenaddedtothelist.3Theseanalyses

3NicholasBloom’s(2017)explanationforinterfirmheterogeneityastheresultofknowledge-intensivefirmsoutsourcinglower-valuework,aggressivelyadoptingIT,andbenefitingfromsomeunspecifiedwinner-take-mostmechanismisarecentexample.

almostalwaysignorethehowandwhythatbroughtabouttheanalyzedcircumstances;yetthisiswhatmattersforcompetitionpolicy,industrialpolicy,innovationpolicy,andtheregulationofcorporategovernance.JudgeLearnedHandcameclosetothehowandthewhyinhisinfluential1945opinioninUnitedStatesvsAlcoawhenhenotedthata“producermaybethesurvivoroutofactivecompetitors,merelybyvirtueofhissuperiorskill,foresightandindustry"(148F.2d416(2dCir.1945)at571).AlineinHand’sopinion4gaverisetothenotionofa“thrust-uponmonopoly,”whichwasusedbytheU.S.FederalTradeCommissioninthe50sand60sasjustificationfornotpursuingantitrustcasesagainstcompaniesmerelybecauseofmarketdominance.Ironically,JusticeHand’sthinkingappears,atleastinsomesmallways,tobeaheadofeconomists.Hisopinionswereaninvitationtoexplainthefoundationsofsuperiormanagerialskill,foresight,andindustry.Behavioraleconomistshaveinrecentyearsprovidedsignificantinsightsintodecisionmaking;butanyefforttoestablishlinksbetweentheseandtheperformanceofindividualfirmshasbeenhandicappedbytheabsenceofacomprehensivefirm-levelframeworksuchasatheoryoffirm-levelcapabilities.

CluesastotheunderlyingreasonsforthelackofprogresscanbefoundinPaulRomer’s(forthcoming)observationthattoomanyeconomistshaveshownloyaltytotheirfriendsand,byimplication,theirown(sunk)investmentinabodyofinadequatetheorythatshouldhavebeenabandoneddecadesago.Romerhascritiquedrationalexpectationsmacroeconomics,pointingouthowthetheoryhasfailedtoexplainmuchofanything;buthismostfundamentalcritiqueisthatthefielddisplaysgreaterloyaltytoitsmembersthanto

4“[I]tmaynothaveachievedmonopoly;monopolymayhavebeenthrustuponit.”(148F.2d416(2dCir.1945)at429).

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thescientificprinciplesthatmustdrivehonestinquiry.Hisconcernisthatmacroeconomicsissufferingfrom“ageneralfailuremodeofascientificfieldthatreliesonmathematicaltheory”,whichincludes“disregardforanddisinterestinideas,opinions,andworkofexpertswhoarenotpartofthegroup”(Romer,forthcoming:7).5Hiscriticismofthepursuitof(false)rigoroverrelevanceisjustasrelevanttomicro-astomacroeconomics.

Critiquesofeconomicformalismarenotnew.Morethanthreedecadesago,NobellaureateWassilyLeontiefworriedpubliclyaboutthistendency:“Yearafteryeareconomictheoristscontinuetoproducescoresofmathematicalmodelsandtoexploreingreatdetailtheirformalproperties...withoutbeingabletoadvance,inanyperceptiblewayasystematicunderstandingofthestructureandtheoperationsofarealeconomicsystem.”(Leontief,1982:107).NobellaureateRonaldCoase,shortlybeforehedied,contributedacolumntotheHarvardBusinessReview(CoaseandWang,2012).AccordingtoCoase:“Economicsascurrentlypresentedintextbooksandtaughtintheclassroomdoesnothavemuchtodowithbusinessmanagement”,whichhas“severelydamagedboththebusinesscommunityandtheacademicdiscipline...Itistimetoreengagetheseverelyimpoverishedfieldofeconomicswiththeeconomy.”Hisplea,however,remainslargelyignoredbythemainstream,evenastheyarequietlyendorsedbyeconomistsworkinginthefieldsofstrategic

5Romersuggeststhatthisfailuremodeoccurs“whenafewtalentedresearcherscometoberespectedforgenuinecontributionsonthecuttingedgeofmathematicalmodeling.Admirationevolvesintodeferencetotheseleaders.Deferenceleadstoeffortalongthespecificlinesthattheleadersrecommend.Becauseguidancefromauthoritycancoordinatetheeffortsofotherresearchers,conformitytothefactsisnolongerneededasacoordinatingdevice.Asaresult,iffactsdisconfirmtheofficiallysanctionedtheoreticalvision,theyaresubordinated.Eventually,evidencestopsbeingrelevant.Progressinthefieldisjudgedbythepurityof

managementandevolutionaryeconomics.Thepointisnotthatformal(dynamic)modelingisn’tuseful;itis.Rather,itisthatthetoolsandmodelsneedtobeembeddedinandconnectedtonarrativesofwhathappensinsidefirms,industries,andecosystems.

Idon’twanttosuggestthatitisonlythepenchantforformalizationthathasdistractedourprofessionfromrealissuesaboutbusinessfirmsandtheirmanagement,eventhoughIsuspectitisthelargestcause.SidneyWinterandI(TeeceandWinter,1984)sketchedoutdeficienciesanddeflections,andtheappendixtothisarticleprovidesanupdatedbillofparticulars.Thereareatleasttwounderlyingculprits:

1. ReductionismandHomogeneity:Economistsseetheindustrysupplycurveasnothingotherthanthesumofindividualfirmsupplycurves.6Thisconstructisconvenient,especiallywhencoupledwithanassumptionoffirm-levelhomogeneity,whichenablesindustrysupplyfunctionstobespecified.However,itignoresinteractioneffectsbetweenfirms,treatsthemasoperatingon(andnotaboveorbelow)anidentifiablesupplycurve,andassumestheyareproducingtherightproduct(s)givenmarketdemands.Noonewhoreadsevenamodicumofbusinessnewscouldpossiblybelievethisisgenerallythecase.Theproblemhereis

itsmathematicaltheories,asdeterminedbytheauthorities”(Romer,forthcoming:7-8).6WhileAlfredMarshall(1920)pioneeredtheconceptoftherepresentativefirmasthebuildingblockfortheindustrysupplycurve,itisalsothecasethatheusedthisasshorthandandthatfirmsare,infact,verydiverse.InIndustryandTrade(Marshall,1919),hewasclearthatfirmsoperateinadynamicenvironmentandthatfirmsthemselveschange.Mathematicalanalysiswasrelegatedtofootnotesandappendices.

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thateconomiststookastheirstartingpointthemathematicalappendixtoAlfredMarshall’s(1920)PrinciplesofEconomicswhereheconstructedthesupplycurve,ratherthanthebodyofthebookandtherestofhiswork,whichclearlyrecognizedfirm-levelheterogeneityandtheimportanceofmanagement.Inadoptingthispath,economistsreadoutofthetheoryofthefirmnotonlyanaffirmativeroleofthemanagerbutalsoanyroleforentrepreneurship(Baumol,1968,2010).

2. NeglectofInnovationandDeepUncertainty:EconomistshavepreferredtofocusonriskandignoreKnightianandRosenbergian(technological)uncertainty,despitetheobviousubiquityofdeepuncertaintyduetotechnologicalchange,politicalfactors,andunforeseeneconomicinteractions.Withrisk,rationaldecisionmakerscanoperatebyapplyingtherulesofprobability.Withdeepuncertainty(theopensetofunknownunknownsaboutwhichnoforecastcanbemade),rationaldecisionmakersfreeze,andatleastoneeconomisthadtoappealtothe“animalspirits”ofinvestorsandmanagerstodrivehismacroeconomicmodel(Keynes,1936).Economictheoryneedstosomehowdevelopatheoreticalstructurethatallowsentrepreneursandmanagerstoinvest,operate,gaininsight,learn,andactinthepresenceofthedeepuncertaintythatispartofeverydaybusinesslife.

Onceeconomistsbegintoacceptthenecessityofaddressingtheselacunae,thetheoryofthefirm—andmicroeconomicsmoregenerally—willbecomefarmorerelevantandcredibletoothersocialscientists,managementscholars,andstudents.ItisthisveryprojecttowhichI’vedevotedmuchattentioninmyownworkbecauseitisnotenoughtosimplycriticize.Onemustalsobuildanalternativetheoreticalstructure

thataffordskeenerinsightsandbetterexplanatorypower.Becausethetheoreticalframeworkoutlinedinthispaperistheeffortofasinglescholar—assistedbygraduatestudents,post-doctoralfellows,and,onoccasion,colleagues—thiseffortisonlyastart,andisverymodestrelativetothescaleoftheproblemathand.

Thereis,inmyview,toomuchtalentdissipatedondevelopingformalagencymodelsofthefirmthatignoreitsmostfundamentalanddefiningelements:its(unique)organizationalandmanagerialcapabilities,andespeciallyitsabilitytoinnovateandtochange.Demsetzinsightfullynotedthateconomictheoryhasshowna“neglectofinformationproblemsthatdonotinvolveagencyrelationships.Theseareassociatedwithplanninginaworldinwhichtheworldishighlyuncertain,andtheyinvolveproblemsofproductchoice,investmentandmarketingpolicies,andscopeofoperations”(Demsetz,1997:428).Unfortunately,hiscritiqueoftheexcessivefocusonagencyissuesdidnotextendtosuggestingaremedyfortheproblem.Itismyhopethatagreaterpercentageoftalentandtimeintheeconomicsfieldwillstart“doingtherightthings”ratherthansimplydoingthings“right,”i.e.,creatingelegantbutlargelyirrelevantmathematicalmodelsoffirmsandtheirinteractions.Gametheory,whenappliedtomarkets,proveseverythingandnothingatthesametimebecausemodelsdevelopedforonesettingareunlikelytoproverobustwhenappliedelsewhere(Sutton,1990).

Clearly,behavioraleconomicshas,inrecentyears,pointedoutissuesrelevanttomanagement:irrationalityispossible,rulesofthumbareubiquitous,andhubrisanddecisiontrapsarecommon.Theseinsights,whileimportant,stillleaveunexplainedkeyelementsofmanageriallyguidedresourceallocationsuchasstrategy,businessmodels,andtheorganizationalcapabilitiesthatimpacttheabilitytotransformthebusiness.

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Intherestofthisarticle,IsummarizesomeofmyrecentworkonwhatI’mcallingacapability-basedtheoryofthefirm.IwillalsoreferencetheworkoffellowtravelerslikeGiovanniDosi,ConnieHelfat,RichardNelson,GaryPisano,andSidneyWinter.Others,includingJayBarney,MichaelJacobides,PeterKlein,RichardLanglois,SohviLeih,FrancoMalerba,MargiePeteraf,andPaulSchoemaker,havejoinedtheparadeofmanagementscholarstakingtheideasofeconomists,challengingthemwherenecessary,andapplyingthemtomanagementandpolicyquestions.

3.TheCapabilitiesViewoftheFirm:AnIntroductionWhiletheprogressofscience,accordingtoKuhn(1963),involvesperiodsinwhichamainstreamparadigmdominates,thesubsequentdiscoveryof“anomalies”leadstotheemergenceofanewparadigmthat,overtime,displacestheold.Suchanomaliesexistineconomicsforverylongperiodswithoutthemainstreambudgingmuchatall.InthespiritofRomer’ssuggestionthat“aresearchprogramoughttoinvolverisk”(Romer,forthcoming:7),Itakeheresomeriskandoutlinearadicalapproachtothetheoryofthefirmthatputscapabilities,andnottheproductionfunctionorproductionsets,centerstage.ThisexerciseisanimatedbymyownconvictionandbyJohnSutton’s(andAlfredChandler’s)observationsthatonecannotadequatelyexplainthewealthofeitherfirmsornationswithoutatheoryofcapabilities.Ibeginbypointingouttheratherwoodennatureoftheapproachtothefirmincontemporaryindustrialorganizationandineconomicsmoregenerally.Resourceallocationineconomicsisprice-guidedorgovernment-guided;theroleoffirmsandtheir

7Modernapproachestodisruption,e.g.,AbernathyandClark(1985),JordeandTeece(1991),Christensen(1997),allsharethisview—implicitlyifnotexplicitly.

managementinguidingresourceallocationislargelyignored.

Thefieldofindustrialorganizationobservedalmostacenturyagothatdifferentindustrieshaddifferentlevelsof(accounting)profits.Thisledtothestructure-conduct-performance(S-C-P)paradigmthatsawconcentratedmarketstructureasthefoundationfortacitorexplicitcollusion,andprofits(Mason,1949,andBain,1959).Althoughseverely(and,inmyview,correctly)challengedbyPhillips(1971),Demsetz(1973),andotherswhosawcausationasgoingfrom(financial)performancetomarketstructure,thestructuralistviewhasnotlostmuchsway,7stillanimatingtoday’santitrust/competitionpolicyandevengivingrisetoPorter’sinfluentialFiveForcesframeworkofcompetitivestrategy(Porter,1980).TheFiveForcesmodelpossiblyhelpsexplainwhythepharmaceuticalindustryishistoricallymoreprofitablethanairlines,andwhyairlineswithstronghubsare,onaverage,moreprofitablethanrestaurants(althoughthismaybechanging).Nonetheless,itleavesmanyquestionsunanswered.Fundamentally,though,theS-C-PparadigmandPorter’sFiveForcesvariantarenotwidelyapplicablebecauseanysupracompetitiveprofitsareduetoasmallnumberoffirmsandindustry-levelstructuralfactors.

ItistruethatPorter’sFiveForcesframeworkfilledavacuuminbusinessschoolsandinmanagementconsulting,providingalaundrylistoffactorstoanalyzesoastoidentifyattractiveindustries.Itdidnothelptheanalystfigureout,however,thecharacteristicsof“good”firms.Moreover,ithasevolvedlittlesinceitsintroductionandhasseriousshortcomings,havingimportedmanyoftheweaknessesofthestructuralistparadigmfromeconomicsuponwhichitwasbuilt.Inparticular,FiveForcesdoesn’taccountforcapabilitiesorforinnovation.Moreover,itfailstorecognizethata

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concentrated,marketstructureisoftentheconsequence(ratherthanthecause)ofsuperiorprofitability.Furthermore,itassumesthat“industry”isameaningfulcategory,andtheunderlyingtheorylacksfirm-levelexplanatorypower.Totakeoneexample,entrybarriersaretreatedasanindustry-levelconstructandarethereforeuselessforexplainingintra-industryperformancedifferences.

Induecourse,theclearexistenceofintra-industryperformancedifferences(Rumelt,1991)wassufficientlyembarrassingthatanalternativeperspectiveknownastheResource-BasedViewemergedtoexplainfirm-leveldifferences.Itgainedalargefollowing(Teece,1982;Wernerfelt;1984;Barney,1991;AmitandSchoemaker,1993),atleastinthefieldofstrategicmanagement.Inthisparadigm,intra-industrydifferencesareexplainedbyfirm-levelownershipofdifficult-to-imitateresources,especiallyintangibleassets.Thesecanserveas“isolatingmechanisms”(Rumelt,1987).8TheapproachbuiltonPenrose(1959)andfoundearlyapplications(inthemanagementliterature)inresearchondiversification.Buttressingtheresourcesapproach,meanwhile,wasimportantworkonoperationsmanagement.Thisrevealedmeasurabledifferencesinperformanceandtechnicalcapabilities(Abernathyetal.,1983;HayesandClark,1986;ClarkandFujimoto,1990)consistentwithLiebenstein’s(1966)notionofx-inefficiency.Bothofthesenewerapproachesweresilent,however,onimportantquestionssuchaswhattechnicalcriteriareallymatteredandwhatresourcesallowedsomefirmstoremaincompetitiveacrossnumerousturnsofthetechnologycycle.Thiscreatedtheneedforevolutionaryeconomictheoryandsomethinglikeadynamiccapabilitiesframework.

Thecapabilitiesviewofthefirmtobeoutlinedbelowlooksbeyond“factorsofproduction”andproduction8Anintermediatestepwastheidentificationof“strategicgroups”consistingoffirmswithinanindustrythathaveadoptedsimilarstrategiesandbusinessmodelsandthatare

functionstorecognizetheimportanceofthechoicesmanagersmaketorenderresourcesmoreproductiveandtomeetcustomerdemand.Italsorecognizesthattechnologyandknow-howdonotfalllikemannafromheavenbutratherresultfromsearch,R&D,andinvestment.Moreover,thecapturingofvaluebyinnovatorsandimitatorsisafunctionofthestrengthofcompetition,theappropriabilityregime,andthenatureoftheindustrialknowledgethefirmcanbuildoracquireovertime.Inthisway,thecapabilitiesviewendeavorstohelpexplaininterfirmheterogeneity,enterpriseevolution,andorganizationallongevity.

I. 3.1Resourcesversuscapabilities

Resourcesarethetangibleandintangibleassets,broadlydefined,thatthefirmcandevelopandeffectivelycontrol.Resources,whichincludetheskillsofthefirm’semployees,itsequipment,andthecollectiveskillsoftheorganization,generatestreamsofservicesthatthefirmcandeploy.AstheorizedbyPenrose(1959)afirmatanypointintimeislikelytohaveunderemployedresources,includingmanagementskills.Afirmwithexcessresourcesmayfinditmoreprofitabletomonetizethoseservicesviaproductdiversificationintonewavenuesofgrowthratherthanthroughamarkettransactionthatleasesaccesstothesurplusservicestoanindependentparty—assumingsuchatransactionwouldevenbefeasible(Teece,1980a,1982).Thesedecisionsareconsistentwiththecapabilitiesapproachtotheboundariesofthefirm,whichwillbediscussedbelow.

Themannerinwhichafirm’sresourcesarecoordinatedandmanagedisatleastasimportanttocompetitivesuccessandsurvivalastheidentityoftheresourcesthemselves.Capabilitiessuchasasset

separatedfromothergroupsbymobilitybarriers(Hunt,1972;Porter,1980).

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orchestrationandmarketcreation(orco-creation)arevitaltoprofitableresourcemanagement(PitelisandTeece,2010).Capabilitiesariseinpartfromlearning,fromcombiningresources,andfromexploitingcomplementaryassets.Manycapabilitiesbecomeembeddedinroutines,andsomeresidewiththetopmanagementteam.Organizationalcapabilitiescanusefullybethoughtofasfallingintooneoftwointerconnected(butanalyticallyseparable)categories:ordinarycapabilitiesanddynamiccapabilities.Ordinarycapabilitiesaretoalargeextentoperationalwhereasdynamiccapabilitiesaregenerallystrategicinnature.

Capabilitiesarenotappropriatelysummarizedbyaproductionfunctionbecausetheyareuntetheredfromparticularproducts.Forexample,acapabilitytomakemachinespoweredbysmall,compactinternalcombustionenginescanmanifestitselfinthemanufacturingofmotorcycles,outboard(boat)motors,ortractorsandlawnmowers.Othercapabilities,suchastheabilitytoofferoutstandingcustomerservice,maynotbetiedtoaparticularproductareaatall.

Ahigher-levelcategoryofcapabilitywaspositedbyTeece,Pisano,andShuenina1990workingpaper(revisedandpublishedin1997).Inthisstreamofresearchinstrategicmanagement,“dynamiccapabilities”(Teeceetal.,1990)areintegraltoselecting,developing,andcoordinatingordinarycapabilities.Thedynamiccapabilitiesframework,whichwillbeamplifiedbelow,hasalsobeenadvancedbyNelson(1991),Chandler(1992),andWinter(2003),amongothers.Thedynamiccapabilitiesframeworkhasbecomeoneoftheleadingperspectivesonthefirminthefieldofstrategicmanagement(DiStefanoetal.,2010).Itseekstoexplainfirmsurvival(orfailure)andlong-rungrowthandfirmsurvival(orfailure)bydetailinghowfirmscancreate,extend,integrate,modify,anddeploytheirresourceswhilesimultaneouslymanagingcompetitivethreatsandeffectuatingnecessarytransformations(Teece,2010a).Althoughitisnotyetfullyelaboratedasatheoryofthe

firm,thedynamiccapabilitiesframeworkbringsWilliamsoniantransactioncosts,Penroseanresources,Knightianuncertainty,andSchumpeterian(knowledge)combinationstogetherinawaythatcanpotentiallyexplainnotonlywhyfirmsexist,butalsotheirscopeandpotentialforgrowthandsustainedprofitabilityinhighlycompetitivemarkets.

II. 3.2Ordinaryanddynamiccapabilities

Thissectionprovidesfurtherspecificationofthetwotypesofcapabilities.

a) OrdinarycapabilitiesOrdinarycapabilities,whichencompassoperations,administration,andgovernanceofthefirm’sactivities,allowthefirmtoproduceandselladefined(andstatic)setofproductsandservices.Ordinarycapabilitiesareembeddedinsomecombinationof(1)skilledpersonnel,including,undercertaincircumstances,independentcontractors;(2)facilitiesandequipment;(3)processesandroutines,includinganysupportingtechnicalmanuals;and(4)theadministrativecoordinationneededtogetthejobdone.

Afirm’sordinarycapabilitiessupporttechnicalefficiency(andhenceproductivity)inperformingafixedgroupofproductiveactivities,regardlessofhowwell-orill-suitedtheoutputsaretothefirm’scompetitiveneeds(Teece,2007:1321).Qualitycontrolmethodologies,performancemeasurementandpayrollexecutionareexamplesofordinarycapabilities.

Ordinarycapabilitiescanbemeasuredagainsttherequirementsofspecifictasks,suchaslaborproductivity,inventoryturns,andtimetocompletion,andcanthusbebenchmarkedinternallyorexternallytoindustrybestpractices.Bestoperationalpracticesarethosethatsupportspeed,quality,andefficiency.

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Bestpracticesalone,however,aregenerallyinsufficienttoensureafirmsuccessandsurvival,exceptinweakcompetitiveenvironments(whicharestillubiquitousinless-developedcountries).Onereasonisthatthereisnobenefitatbeingverygoodatdeliveringthe“wrong”productsaftermarketdemandshifts.Furthermore,muchoftheknowledgebehindordinarycapabilitiescanbesecuredthroughconsultantsorthroughamodestinvestmentintraining(Bloometal.,2013).Asaconsequence,goodandeven“best”practicesdiffusemoreorlessquicklyatleastamongstthosefirmsinenvironmentsexposedtostrongglobalcompetition.Suchfirmsarelikelytobeawareofbenchmarkingdata,canacquireandabsorbcompetitiveoff-the-shelftechnologies,andcanimplementbestpracticetraining.

Forexample,themultidivisional(M-form)organizationalstructurediffusedacrosslarge-scalecorporationsinthemiddleofthe20thcentury.Inthepetroleumindustry,themajorityofleadingfirmsadoptedanM-formstructureoveraperiodofabout15years(Armour&Teece,1978;Teece,1980b).Oncethisorganizationalbestpracticebecamecommonplace,thehigherprofitsthathadaccruedtoitsearlyadoptersintheU.S.petroleumindustrydissipated.

Eventhoughthediffusionofbestpracticesclearlyisn’trapidorcomplete,beingatopperformerinproductivityisunlikelytoleadtosupernormalprofitsbecauseitonlytakesafewfirmsatthefrontiertodrivepricesdowntocompetitivelevels,therebydissipatinganyeconomicrents.Putdifferently,evenifbestpracticesaren’tuniversallyadopted,theiradoptionisunlikelytosupportreturnsabovecompetitivelevels.

Ingloballycompetitivefirmsfacingstrongcompetitioninadvancedeconomies,whereprofitshavethegreatestpotentialtobesizable,arelativelyhighlevelofordinarycapabilitiesexists,andbestpracticesare

9Theadventofdriverlessandelectriccarsisturningthebasicdesignparadigmofacaronitshead,andcertainnew

closetouniversal.BobLutz(2011),theformervicechairmanatGeneralMotors,illustratesthispointfortoday’sautomotiveindustry9:

Theoperationsportionoftheautomobilebusinesshasbeenthoroughlyoptimizedovermanydecades,doesn’tvarymuchfromoneautomobilecompanytoanother,andcanbemanagedwithafocusonrepetitiveprocess.It...requireslittleinthewayofcreativity,visionorimagination.Almostallcarcompaniesdothisverywell,andthereislittleornocompetitiveadvantagetobegainedby“tryingevenharder”inprocurement,manufacturingorwholesale.

Justbecauseoperationsarenotatpresentadifferentiatorintheindustrydoesnotmeanthattheyarenotimportantatanaggregatelevel.Therearesignificantdifferencesinproductivityamongfirms(Dosi,2007),andproductivitygapswidenedinthe2000s(OECD,2015).Thistranslatesintoagreatdealofunrealizedvalueforsociety.Doingordinarythingswellcansupportthejobsassociatedwithsurvivingin“metoo”commoditycompetition.However,itcannotleadtolevelsofexceptionalprofitabilitythatdriveinvestment,employmentgrowth,wagegrowth,andtheeconomicexpansionassociatedwithbusinessleadership.Thisisinpartbecause,asmentionedabove,thepresenceofwell-developed(best-practice)ordinarycapabilitiesinafirmsaysnothingaboutwhetheritscurrentproductionmixistherightpathforthepresentorthefuture.Infact,strongordinarycapabilitiescanleadafirmintocomplacency;atrapissprungwhenmarketconditionschangebecauseasingle-mindedpursuitofefficiencyandproductivitycandriveoutthecapacitytoeffectuatechangetowardsthenewsuiteofproductsandprocessesthemarket

ordinarycapabilities(e.g.,buildingbatteries)arebeginningtomatter.

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requires.10Indeed,O’ReillyandTushman(2013)pointtohowthepursuitofefficiencycanstandinthewayofinnovation.

Thefundamentalproblemisthatefficiency/productivity,whichissomuchemphasizedin(static)economictheory,ignoresinnovationandthetransformationofmarketsandorganizations.Inertiaisofteninadvertentlyimposedonorganizationsbyeffortstooptimizeprocessesandachievebestpractice.Notsurprisingly,empiricalresearchontheeffectsofprocessmanagementpracticesfailstoyieldconclusiveevidenceofbenefits.Powell(1995)andSamsonandTerziovski(1999)didnotfindevidencethattheemploymentofprocess(optimization)technologiesaidedenterpriseperformance.Indeed,someevidence(e.g.,Garvin,1991)suggeststhecontrary.Thepayofftobetterprocessmanagementisdoubtful,exceptinanindustry’speriodsoftechnologicalstability.AsBennerandTushman(2003)noted:“Activitiesfocusedonmeasurableefficiencyandvariancereductiondriveoutvariance-increasingactivitiesand,thus,affectanorganization'sabilitytoinnovateandadaptoutsideofexistingtrajectories...Corecapabilitiesmaybecomecorerigidities”(BennerandTushman,2003:242).

Asapracticalmatter,theperceivedneedtomaintainbestpracticeandhighproductivitycandistracttopmanagementfromfocusingoninnovationsoastodeveloptherightproducts.Doingthingsright(technicalefficiency)isnotthesameasdoingtherightthings.Doingtherightthingssupportsevolutionaryfitness.Moreover,asJohnChambers,formerCEOofCiscoSystems,hasobserved,companiesmustbewillingandreadyto“changefromdoing‘therightthingtoolong’to‘thenextbigthing’”(Chambers,2017).This

10HenryFordlearnedthisthehardway.TheFordMotorCompanyusedverticalintegrationtooptimizetheproductionprocessfortheModelT.Thisworkedwelluntilthemarketshifted.Bringingafollow-onproduct,theModel

ongoingevolutionaryfitnessisthegoalofdynamiccapabilities.

b) DynamiccapabilitiesAsnoted,dynamiccapabilitiesareaboutdoingtherightthings,attherighttime,basedonnewproduct(andprocess)development,uniquemanagerialorchestrationprocesses,achange-orientedorganizationalculture,andaprescientassessmentofthebusinessenvironmentandtechnologicalopportunities.Strongdynamiccapabilitiesarepossessedbythefew,notthemany.

Strongdynamiccapabilitieshelpenableanenterprisetoprofitablybuildandrenewresources,reconfiguringthemasneededtoinnovateandrespondto(orbringabout)changesinthemarketandinthebusinessenvironmentmoregenerally(PisanoandTeece,2007;Teeceetal.,1997).Theyallowtheenterpriseanditstopmanagementtodevelopconjecturesabouttheevolutionofconsumerpreferences,businessproblems,andtechnology;validateandfine-tunethem;andthenactonthembyrealigningassetsandactivities.Successfullybuildingstrongdynamiccapabilitiesallowsfirmstochallengecompetitorsthatprioritizeefficiencyoverinnovation,thatignore(orareignorantof)changingcustomerneeds,orthatfailtoempowerinternalentrepreneursandchangeagents.

Forappliedpurposes,dynamiccapabilitiescanusefullybebrokendownintothreeprimaryclusters:(1)identification,development,codevelopment,andassessmentoftechnologicalopportunitiesinrelationshiptocustomerneeds(sensing);(2)mobilizationofresourcestoaddressneedsandopportunities,andtocapturevaluefromdoingso(seizing);and(3)continuedrenewal(transforming).Engagementincontinuousorsemi-continuoussensing,

A,tomarketwasalongandarduousprocessthatallowedGeneralMotorstogetaheadofFord,aleadershipposition,GMheldfordecades.

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seizing,andtransformingisessentialifthefirmistosustainitselfascustomers,competitors,andtechnologieschange(Teece,2007).

Dynamiccapabilitiesreside,inpart,withindividualmanagersandespeciallythetopmanagementteamwhoarerequiredtotakeanentrepreneurialroleindetectingandexploitingopportunities.Atcertaincriticaljunctures,theabilityofaCEOandthetopmanagementteamtorecognizeakeydevelopmentortrend,thendelineatearesponseandleadthefirminitspathforward,mightbethemostprominentfeatureofthefirm’sdynamiccapabilities.Buttheorganization’svalues,culture,andcollectiveabilitytoquicklyimplementanewbusinessmodelorotherchangesarealsointegraltothestrengthorweaknessofthefirm’sdynamiccapabilities(Teece,2010b).

Thedynamiccapabilitiesapproachhelpsexplainwhyintangibleassets,includingafirm’scollectiveknowledgeandcapabilities,havebecomethemostvaluableclassofassetsinawiderangeofindustries(HultenandHao,2008).Thereasonisthatknowledge,capabilities,andotherintangiblesarenotonlyscarce;theyareoftendifficulttoimitate.

BobLutz(2011)ofGeneralMotors(echoingAbernathy,1978)putthisaspectofdynamiccapabilitiesrathersuccinctlyfortheautoindustry:

Wheretherealworkofmakingacarcompanysuccessfulsuddenlyturnscomplex,andwherethewinnersareseparatedfromthelosers,isinthelong-cycleproductdevelopmentprocess,whereshort-termday-to-daymetricsandthetabulationofresultsaremeaningless.

Inotherwords,ordinarycapabilitiesdonotdeterminewhetherthecurrentproductionschedulewillbetheright(orevenaprofitable)pathtofollowinthefuture.Strongordinarycapabilitiesarevaluableonlyduringagivenmarketwindow;theyareinsufficienttoundergirdsustainablecompetitiveadvantageasthebusinessenvironmentchanges.What’sneededissome

kindofdynamicoptimization,ratherthanthestaticoptimizationthatisnormallypracticed.LouGerstner,IBM’sformer(turnaround)CEOputitthisway:

Inanythingotherthanaprotectedindustry,longevityisthecapacitytochange...Rememberthattheenduringcompaniesweseearenotreallycompaniesthathavelastedfor100years.They’vechanged...andtheyaren’tthesamecompaniesastheywere.Iftheyhadn’tchanged,theywouldn’thavesurvived.Ifyoucouldtakeasnapshotofthevaluesandprocessesofmostcompanies50yearsago—anddidthesamewithasurvivingcompanyin2014—youwouldsayit’sadifferentcompanyotherthan,perhaps,itsnameandmaybeitspurposeandmaybeitsindustry.Theleadershipthatreallycountsistheleadershipthatkeepsacompanychanginginanincremental,continuousfashion.It’sconstantlyfocusingontheoutside,onwhat’sgoingoninthemarketplace,what’schangingthere,noticingwhatcompetitorsaredoing.(DavisandDickson,2014:125).

Dynamiccapabilitieshavetobe“built”throughaprocessofinvestmentindiscovery,knowledgegeneration,andlearning.AsAppleCEOTimCooksaidinFebruary2013withreferencetothecompany’sabilitytointegratehardware,software,andservices:“Applehastheabilitytoinnovateinallthreeofthesespheresandcreatemagic.…Thisisn'tsomethingyoucanjustwriteacheckfor.Thisissomethingyoubuildoverdecades”(AFP,2013).

Table1summarizesimportantdistinctionsbetweenordinaryanddynamiccapabilities,andTable2alignsstrategyanddynamiccapabilityconcepts.

<TABLE1ABOUTHERE>

<TABLE2ABOUTHERE>

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III. 3.3Capabilitydevelopment

a)Calibratingcapability“distance”Lestdynamiccapabilitytheorybeimpugneditselfforbeinginsufficientlydynamic,theissueofhowcapabilitiesarebuiltneedsconsideration,too.Hereitisusefultodistinguishbetweenthedemandside(i.e.,whatconsumerswant)andthesupplyside(i.e.,howfirmsbuildcapabilitiesifwhatthemarketwantsandwhatthefirm’stechnologyandorganizationallowarenotsynchronized).

Inthedynamiccapabilitiesframework,sensingmayleadtothediagnosisofamarketandcompetitivesituationthatrequirestransformingandthebuildingofcapabilitiesinsidethefirmthatdon’tcurrentlyexist.Howcanthisbebroughtabout?Inessence,whatisrequiredislearninghowtodonewthings,possiblyutilizingquitedifferentbusinessmodels.Inthisregard,thequestionof“distance”fromcurrentpracticesishighlighted.Inourframework,capabilitydistanceforanincumbentfirmcanbecalculatedonthreedimensions(Figure1):

1. Technicaldistance:Atechnologicalchallengecanbeincremental(insideanexistingtechnologyparadigm)orradical(outsidetheparadigm).Iftheformer,kaizen(continuoussmallimprovementstoexistingtechnology)willoftengetthejobdonewiththeexistingresourcebase.Ifthechallengeisradical,thenR&Dand/oropeninnovation(i.e.,technologyoutsourcing)willberequired.Thechallengeisparticularlysevereincompetitivetermsifitisradicalforthefocalfirmbutincrementalforarival.Hence,“radical”istosomeextentarelativeconcept.

2. Marketdistance:Thetargetmarketcanbenearorfar.Marketdistanceincreasesasthefirmreachesfornewpoolsof

customers,perhapsinanewgeographywithculturaland/orregulatorybarriers.

3. Businessmodeldistance:Distancealsohasabusinessmodeldimension.Doesthenewtechnologyrequirearadicallydifferentrevenuemechanism?Willtheexistingcoststructureremainprofitable?Doesthefirm’scurrentmixofoutsourcingandin-houseactivitiesneedtochange?

Whenthecapabilitygoalliesclosertotheorigin(pointOinFigure1),itisrelativelyeasiertoachieve.Thefurtheroutoneachaxis,theharder.Multipliereffectsforchangesinvolvingmorethanonedimensionmakethechallengegreaterstill.

<FIGURE1ABOUTHERE>

b)Closing(ordinaryanddynamic)capability“gaps”Closingcapabilitiesgapsbetweenwhatcompanieshaveandwhattheyneedissomethingweknowalittlemoreabout.Capabilitygapsareofatleastthreekinds.

• Closingtechnologygaps:Thecontemporaryliteratureisrichwithrespecttohowtechnologygapsgetclosed.Thediscussionhasprogressedfromstandardtechnologytransferissues(licensing,technologyassistanceagreements,etc.)tousingtheSECIprocess(Nonaka,1991)andtousing“openinnovation”(Chesbrough,2003),whilenotforgettingtraditionalinternaldevelopmentthroughcorporateR&D.ThecriticalityofR&Dandnewproductdevelopmenttothiseffortwillvarywiththemagnitudeofthegapthatmustbeclosed.Newtalentwilllikelyneedtobehiredifthegapisconsiderablewhetherthetechnologyistobedevelopedin-houseorabsorbedfromanexternalsource.

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• Closingmarketgaps:Addressingnewmarketsegmentsrequiresadeepunderstandingofcustomer“needs”,whichhasculturalandeconomicdimensions.Themostvaluableknowledgeaboutcustomerscomesfrominteractingwiththeminmultiplemarketsegments.Dataanalysisisausefulsupplementtoexperientialknowledge.

• Closingbusinessmodelgaps:Theemergenceofnewtechnologyandmarketneedscansometimesrequireadjustingthewaybusinessisdone.Forinstance,theInternetisallowing(andrequiring)onlinesales.Brick-and-mortarstoreshavetoimprovetheirtraditionalapproaches,adoptthenew,orrunbothinparallel.Evenmaturesectorssuchasoilandgasarenotimmunefromtechnologyandothershocks,astheindustryexperiencespolicyuncertaintyaroundenvironmentalconcerns,theemergenceofnewtechnologiessuchashydraulicfracturing,andnewassertivenessamongstate-runoilandgascompanies(Shuenetal.,2014).Thereisaliteraturetohelpunderstandeachof

theabovegapsinisolation,butlittletohelpunderstandhowtomanageallthreeatonce.Whenallthreemustbechanged,thefirmmustundergoaradicaltransformation.Inasmuchasbusinessorganizationhassystemicdimensions,itisimportanttorecognizethatourunderstandingofsocialandorganizationalsystemsisoftenlimited.Suchanadmissionimpliesthatthebusinessriskassociatedwithclosingcapabilitygapsislikelynon-linearwiththenumberofgapstobeclosed.

Thereareatleasttwoclassesofphenomenaembeddedinunderstandinghowtoclosecapabilitygaps:(1)learningand(2)transformation.Bothrequireleadership.Organizationswon’tlearnunlesstheyareencouraged—andgiventhemeans—todoso.Norwilltheytransformunlesstheleadersoftheorganizationareinthevanguard.Thisiswellknown,buta

systematicefforttoincorporatesuchnotionsintocapabilitytheoryisjustbeginning(Teece,2016).

Whetherordinaryordynamic,therearecertainsystemicchallengesinclosingcapabilitygaps.Thefirstchallengeistoactuallyunderstandthelocationandmagnitudeofcapabilitiesdeficiencies.Oftenitisonlyafteranorganizationtriestodosomething(andfails)thatthegapisapparent.Theearlyphaseofaprojectlooksokaybecausetherearetypicallyfewoutcomesmetricstoevaluate;lateron,problembegintocropup,theseniorteamgetsmoreandmoreinvolved,andthegoalslipsfurtheraway.Adhoc“solutions”areattemptedandfailed.Finally,thereisgeneralrecognitionofacapabilitygap.

Theremayormaynotbearesourcegap.Resourcesarenotcapabilities.Theremaybebudgetsandpeopleassignedtoaproject;but,ifthepeoplearenotchosencorrectly,performancefailureismorelikely.Manyprojectsandprogramsfailbecauseofanorganization’sinabilitytodevelopandintegratethecapabilitiesneededtodesign,develop,anddeliver.Strong(ordinary)capabilities(andnotjustresources)areneededtogetthingsdone.

Whatiscriticalareabilitiesto(1)recognizewhatcapabilitiesareneededand(2)developthemquickly,efficientlyandeffectively.Thesecapabilitiesthemselvesarekeypartsofdynamiccapabilities(FeilerandTeece,2014).

Dynamicallycapablefirmsareagile.Toooften,though,agilityisdefinedastheabilitytodocommonplacethingsfasterandcheaper.Ifthat’swhatonemeansbyagility,itismoreakintoordinary(ratherthandynamic)capabilities.Whenagilityreferstoareductioninthetimerequiredtoreachbestpractices,itissimplyanincantationforSixSigma,ValueEngineering,orotherefficiencyinitiatives.Thosemaybenecessaryfortheorganizationtobecomemoreefficient;buttheyareonlysecondarilyrelatedtoconferringevolutionaryfitness,i.e.,beingmore

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effective,moreabletogetnewthingsdone,andmorefocusedontherightthings.

Strategicagilityismoreabouteffectivenessthanefficiency.Thetopmanagementteammustidentifyopportunitiesandrecognizegapsintheresourcesandcapabilitiesthattheorganizationneedstoaddressopportunitiesandthreats.Theorganizationmustbeabletolearn,absorbandimprovethenecessaryprocesses.Whileexistingbusinessesneedbestpractices,new,materiallysignificantinitiativesgenerallyrequirenewcapabilities.Afocusonthemaintenanceoffinancialperformanceoverthecreationofnewcapabilitiesactuallyimpairstheabilitytodeliverbetterresultsinthelongerrun.Ataminimum,masteringacapabilityrequirescreatingthecapacityforarepeatperformance.

Whiletherearewell-documentedpracticesformany,ifnotmost,ordinarycapabilities,therearefewdocumentedprocessesforbringingnewcapabilitiesonline.Anorganizationhasfewornointernalreferencepointsforhowtodowhatithasneverdonebefore.Theremaybeindividualswithsomeoftherequisiteknowledge,butmanagementmaynotknowwhotheyare.Moreover,theorganizationmaynotknowwhat“excellence”inthetargetcapabilitylookslike.

Establishingnewcapabilitiesrequiresleadershipandteamwork.AsmanagementexpertDavidJohnstondescribesit:

Itellteamsaswearegettingorganizedandpullinginneededcapabilitiesthatweareaimingfor"crackle".Itishardtodescribethephenomenon,excepttosaythatwestarttoworkmultiplestepsahead,makingdecisionsnowthatdon'tsimplyservicethenextmilestone,buttherealendpoint...Thereislittledebateoverhowtogoaboutsomething,andlittledebateoverwhatisgoodenough—thisisarealcontrasttolower-capabilityteamswherenearlyeverythingbecomesmatterfordiscussionanddebate

...Wereversetheratiooftalking-to-doingfrom80-20to20-80.Thingshappen.(Johnston,2017)

Johnstongoesontonotethatexcellenceinbuildingcapabilitiesoftencombinesinternalandexternalsourcesofknowledge.Inhiswords,itrequires:

havingreadyaccesstogreathelpandactingonit.Italsomeansthatifwedon'tknowexactlywheretogethelp,weknowsomeonewhodoes.Wedon'treinventwheels,wedon'tbeatourheadsagainstwalls,wedon'tpretendourwaythrough;wediscardhubrisandego,andwerecognizethatgreatnesscomesfromfindingthesolution,notfromtryinghardortalkingsmoothly.(ibid.)

Thesearchforcapabilitygapsbeginsbyexaminingthematchbetweenaproposedbusinessmodelandthefirm’sexistingcapabilities.Ananalysisofexistingcapabilitiesneedsanobjectivepointofviewthatisdetailedandrealistic.Organizationalinstinctstendtocompeltheexaggerationofcurrentcapabilities.

Thecapabilitiestobeassessedaretechnical,market,andbusinessmodel-related.Theyareundergirdedbybusinessprocessesthatsupportmaking,storing,selling,shipping,delivering,andthehandlingoftransactions,returns,andcomplaints.Somecompaniesgointoanewlineofbusinessandareslowtocometogripswithmanyofthesebusinessprocessesuntilrequired.Lateinthegame,theydiscoveranumberofbusinessprocessesthatreallyshouldhavebeenconsideredintheproductrequirementsanddesign.Thereisthenquiteascrambletodecidewhattodoandhowtodoit.Marketentryisdelayedandcostssoar.Adriveforinsightonsuchmattersispartofdynamiccapabilities.

Some(ordinary)capabilitieshavemultipleoptionsbywhichtheymaybeacquired.Seniorleaders

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seekingtobuildordinarycapabilities,canexercisethefollowingthreeoptionsaloneorincombination:11

1. Make:choosetodevelopthenewcapabilityintheexistingorganizationbyselectinganddevelopingpeople,teams,theirmethods,tools,processes,trainingthemandotherwiseexposingthemtonewwaysofdoingthings;

2. Buy:acquirethenewcapabilitybypurchasinganexistingorganizationorbyhiringkeyindividualswiththeknowhowrequiredtoimplementone;

3. Rent:addthenewcapabilitythroughmoreorlesstemporarycontractsandconsultants.

The“make”optiontakestime,effortandskill.Arobustcapabilitybuildingprocessrequirestheconsciousattentionofmanagement.Topositiontheorganizationforexcellenceinanewcapabilityusingtheexistinginternalteamcanbeparticularlychallengingbecausein-houselearningprocessesaredifficulttoaccelerate.Successalsorequiresaccountability,whichisaidedbytheuseofobjectivemeasuresagainstagreed-upongoals.

The“buy”optioncanbeproblematicasafirststep,thoughitisoftentheonetaken—maybeevenmostoftentaken.Buyingofteninvolveshiring;butwhomtohire?The“buy”optiontoaddorenhancecapabilitiesshouldprobablybelowerrankedunlessoruntilitisunderstoodwithreasonableprecisionwhatisneeded,includingwhatconstitutesexcellenceinthetargetcapability.

The“rent”optioncanbeapowerfulacceleratorforcapabilitydevelopment.Itinvolvesusingconsultantstojump-starttheestablishmentofa

11ChesbroughandTeece(1996)outlinesomeoftherelevantelements(seebelow).

capabilityatahigh(bestpractice)levelinordertoproducegoodresultsfairlyquickly.Abarriertothesuccessofrentingcanberesistancefromtheexistingorganization.Theoptionrequiresaconsciousdirectionfromseniorleaderstoendorsethedirectionbeinggivenbytheoutsidefirmaspartofastrategicvisionandsetexpectationsforthebehaviorchange.

Gettingcapabilitiesintoplaceacrossallneededfunctionsandgeographiesisachallenge.Onecriticalrequirementisalignment.Incommonpractice,“alignment”isoftenusedtomeanacquiescenceonaparticularissue.Itrarelymeanswhatitneedstomean,namelymutualunderstanding,agreement,andactioninsupportofstrategicgoals.Acquiescenceisshallowandeasilyabrogated.Strategicalignmentisdeep,committedandaccountable.

Manycapabilities(anddynamiccapabilitiesinparticular)cannotbebought;theymustbebuilt.Inthecaseoforganizationalcoherence,forexample,theabilitytoknowhowprocessesandfunctionsneedtofittogetherislargelyamatterofidiosyncraticexperience.AnotherinappropriatecandidateforoutsourcinginmostcasesisR&Dandothertechnologicalinnovation,particularlywherethefirmneedsto“pace”thetechnologysothatitdevelopsinlinewithotherpartsofasystem(ChesbroughandTeece,1996).Managersmustlearntosynchronizetheeffortsofmarketing,R&D,operations,qualityassurance,etc.,tounderstandtheirperspectives,andtoeffectivelydrawthemintoacoordinatedwholeinwaysspecifictoaparticularcompanyataparticularstageinitstrajectory.Beingabletounderstandwhothestakeholdersare,toelicittheirneeds,todevelopinteractivebusinessprocesses,tocreateinternaldocumentationandcommunicationsystemsaremoreexamplesofcapabilitiesthataredifficultandprobablyinappropriatetooutsource.Infact,theseintegrativecapabilitiesareofteninvisibleto

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organizations,withmanagementbeingonlyvaguelyawareofthelearningthatneedstotakeplace.Anintegrativecapabilitymayemergeinthecourseofaproject,butitmaynotpersistwithoutconsciousrecognitionandnurturing.Ifconsciouslydeveloped,suchacapabilitycangeneralizeandbecomeadynamiccapability.

Buildingcapabilitiesishard;thesilverliningisthat,oncebuilt,theyarethendifficultforotherstoimitate.Putdifferently,theabsenceofamarketforcapabilitiesmeansthatbenefitscanflowfromentrepreneurialandmanagerialactivitythatbuildsandhonesvalue-creatingcapabilities.Oncesuchcapabilitiesexist,theastuteimplementationofvaluecapturestrategiescanfuelgrowthinprofits.

IV. 3.4Dynamiccapabilitiesandstrategy

Strategy,whendevelopedsuccessfully,involvesdoingtherightthings—deployingthefirm’sscarceassetsincalculatingwaysandaligningitsprocessestooutmaneuvercompetitorsbytakingadvantageoftheirmistakes,leveragingin-housestrengths,andovercominganyconstraintsimposedbythefirm’slegacy.Itisthusacriticaladjunctofdynamiccapabilities.

Putdifferently,themanagerialorchestrationthatiscoretoenhancingprocessesandexploitingpositionsmustbeguidedandinformedbystrategy—andvice-versa.Strategyneedstobeconsistentandcoherent.Althoughthefirmisconstrainedtosomeextentbywhatithasdoneinthepast,itcanstillshapethepathahead.Dynamiccapabilitiesguidedecisionssuchaswhichproductstomakeorwhichcustomerstotarget.Strategyhelpstodeterminethetimingofmarketentryandhowtokeepcompetitorsatbay.

Astrategycanbedefinedas“acoherentsetofanalyses,concepts,policies,arguments,andactions

thatrespondtoahigh-stakeschallenge”(Rumelt,2011:6).AccordingtoRumelt(2011),agoodstrategyhas(1)prescientdiagnosesthatidentifyobstacles,(2)aguidingpolicyspecifiesanapproachtoovercomingthem,and(3)coherentactionconsistsoffeasiblecoordinatedactivitiesthatimplementthepolicy.Agoodstrategywilloftennotappearfullyformed,butinsteademergeoveraperiodoftrialanderror(providedthebusinessenvironmentissufficientlyforgivingtoallowexperimentation).Whiletheactionsdictatedbythestrategymaybevisibletorivalsandfreelyimitable,rivalsmaynotperceiveitintheirinteresttodosountilitistoolatebecausetheunderlyingdiagnosisandpolicycanbekeptsecret.

Whiletheyareanalyticallydistinctconcepts,strategyanddynamiccapabilitiesare,inpractice,closelyrelated.Forinstance,sensingisimportanttodynamiccapabilitiesbutalsocontainsastrongelementofdiagnosis,whichisimportanttostrategy;seizingneedstobeconnectedtobothaguidingpolicyandcoherentaction;andtransformingthatisvalueprotectingandenhancingrequiresaguidingpolicyandcoherentaction.

Dynamiccapabilitiesandbusinessstrategiescodetermineperformance(Figure2).Strongdynamiccapabilitiesstillrequireasoundstrategy.Firmswithweakercapabilitieswillrequiredifferentstrategiesfromfirmswithstrongercapabilities.Andtheeffectivenessofdynamiccapabilitieswillbecompromisedbypoorstrategy.

<FIGURE2ABOUTHERE>

4.Capabilities:AntecedentsinEconomicTheoryTheconceptofcapabilitiesoutlinedaboveisnotcompletelyalientoeconomics.Organizationalcapabilitieshaveappearedperiodicallyintheeconomic

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literature,connectedmostoftenwithnotionsofproductivity.12TheirlineagecanbetracedatleasttoMarshall(1920:322)whorecognizedthatmanagerialcapabilitiesmatter.Despitehisuseoftherepresentativefirmassumption,hesawfirmsasbeingdifferentfromoneanother.Healsorecognizedtheneedforanevolutionary/capabilityapproachtoeconomics,noting

Weshallneedevermoretothinkofeconomicforcesasresemblingthosewhichmakeayoungmangrowinstrength,tillhereacheshisprime;afterwhichhegraduallybecomesstiffandinactive,tillatlasthesinkstomakeroomforotherandmorevigorouslife.

Asexplainedbelow,Marshall’sreferenceto“strength”isalignedwithcapabilities,evolutionaryeconomics,andnotionsoffirmheterogeneity.JoanRobinson(1977:1324)notedthatMarshall“describedindustryasaforestinwhicheachindividualtreegrowsonlytoacertainheight.”

AfirststeptowardexplainingthisinterfirmvariationwasmadebyPenrose(1959),whodescribedtherelationbetweenafirm’sresourcesanditsproductionoffinalproducts.Richardson(1972:888)furtherdevelopedtheidea,positioningcapabilities,whichhedefinedasthefirm’s“knowledge,experienceandskills,”asthedriverof,andconstrainton,theactivitiesofthefirm.Demsetz(1976:373)pointedtothe“inherentcapabilitiesofproducers”asapossiblesociallybenignexplanationforlargemarketshares.Thetermhascontinuedtobeusedinthiscontext(e.g.,Bresnahan,1992).Morerecently,Matsusaka(2001)developedadynamicmodelofcorporatediversificationinwhichacquisitionanddivestmentaredrivenbyeffortstomatchafirm’sactivitiestoitscapabilities.Capabilitiesweredefinedas“the

12Aneconomicconceptsimilartocapabilitiesis“organizationcapital.”ThephrasewasintroducedbyPrescottandVisscher(1980)asaproxyforproprietaryinformationthatafirmgathersaboutitsemployeesand

combinedmarketing,distribution,anddevelopmentskillsoftopandmiddlemanagement”(Matsusaka,2001:428).Thecapabilitiesmodelshowshowdiversifiedfirmscantradeatadiscountevenwhendiversificationisvalue-maximizing,whichcontradictstheresultsofagencymodelsofdiversification.

JohnSutton(2002)hasequated“capabilities”morenarrowlywiththeabilitytoenhanceproductqualityandreducecost.However,intheterminologylaidoutearlier,suchcapabilitiesareonlythe“ordinary”capabilitiesrelevanttoanenterpriseremainingcompetitiveinestablishedmarkets,notthedynamiccapabilitiesthatcanpotentiallyhelpthecorporatetreetogrowbeyondits“certainheight”.Nevertheless,inwritinglessformallyonthecapabilitiesrequiredforeconomicdevelopment,Suttonhashighlightedtheability(whatcanbeclassifiedasadynamiccapability)ofmanagerstoselectpromisingmarkets(Sutton,2012).

Althoughhedidnotusethelanguageofcapabilities,Garicano(2000)introducedamodelofafirminwhichworkersareinvolvedeitherinproductionorinsolvingproblems.Thismodelcapturesessentialfeaturesoftheprocessbywhichfirmsharnessresourcestodevelopnewcapabilities.Thismodelofaknowledge-basedfirmwaslaterembeddedbyGaricanoandRossi-Hansberg(2012)inageneralequilibriummodelinwhichinnovationsdisplaceoldproductsandleadtothefoundingofnewfirmsthatlearnandbuildinternalhierarchies.AnothermodelthatcaptureselementsofthedynamiccapabilitiesframeworkwithoutdirectlyreferringtoitwaspresentedbyDesseinandSantos(2006).Intheirmodel,firmsmovetooneoftwoequilibria:astrongdivisionoflaborresultinginorganizationalrigidityoraninternalsystemofflexiblecoordinationthatpermitsbetteradaptationtolocal

theirtasks.Ithassincebeenmademoregeneral,encompassingafirm’s“operatingcapabilities...investmentcapabilities....andinnovationcapabilities”(LevandRadhakrishnan,2005:75).

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changesincircumstance.Worksuchasthisshowsapromisingavenuefortheincorporationoforganizationalcapabilitiesandrelatedconceptsintoformalmodels.

Forthemostpart,however,theconceptofcapabilitiesinmoderneconomicshasmigratedfromtherichanddynamicenterprisegrowthfocusofMarshallandPenrosetoanarrowerconceptionmoreconsistentwithastatic,production-functionmodelofthefirm.Thisisdisappointingandhasdeeplyimpairedtheabilityofeconomictheorytoinformmanycontemporaryissues.Somethingbetterisneeded.

5.Anew(capability)theoryofthefirmcenteredaroundmanagingunderdeepuncertainty,innovation,andbuilding/deployingnon-pricedassetsThedynamiccapabilitiesframeworksketchedaboveincorporatesanentrepreneurialtheoryofthefirmthatstartsfromamoreprimitiveinitialstatethantheoneassumedinmosteconomicmodels.IntheCoase-Williamsonframework,forexample,manymarkets,technologies,andpricesexistalready(BoudreauxandHolcombe,1989).Inreality,entrepreneursmustfirstcutthroughuncertaintyandcreateeachmarketbeforetherearepreferencesandpricesthatcanleadtomarketactivity,anobservationthatdatesbacktoatleasttheworkofFrankKnight(1921).

V. 5.1Deepuncertainty

Deepuncertaintyisubiquitousintoday’scomplexinterdependentbusinessworld.Majorunexpectedshocks,dubbed“BlackSwanevents”byfinancial13U.S.DepartmentofDefenseNewsBriefing,February12,2002.Thephrase“unknownunknowns”wasalreadyinfrequentuseatNASAandperhapsappearedfirstina1982

theoristNicholasTaleb(2007),occur“outsidethemodel.”Yet,asTalebargued,sucheventsoftendrivechangesinthefortunesofcountriesandcompanies.

Whilelarge-scaleshocksarerare,smallershocksarefairlyfrequent.Small,frequent,andunanticipatedshocksareparticularlycommoninthetechnologicalarena.Allindustriesarecompetinginaworldwherecapabilitieshavespreadtomoregeographicregionsthaneverbeforeandinterconnectednesscanpropagateshockwavesfromonce-obscurecornersoftheglobetomajormarketsintheturnofanewscycle.AsventurecapitalistWilliamJaneway(2012:105)noted,“theInnovationEconomy...issaturatedinunquantifiableuncertainty.”

Nearlyacenturyago,FrankKnightrecognizedthat:

Withuncertaintypresent,doingthings,theactualexecutionofactivity,becomesinarealsenseasecondarypartoflife;theprimaryproblemorfunctionisdecidingwhattodoandhowtodoit.(Knight,1921:268)

Practicallyallofthetraditionalapproachestothefirmimplicitlyassumerelativelypredictableenvironments.Theseapproachesmayrecognizerisk,buttheyignoredeepuncertainty.Ineffect,theyassumethatuncertaintycanbemanagedinthesamewayasrisk.Accordingly,theyareoflittlehelptomanagersfiguringouthowtocompeteinenvironmentscharacterizedbytechnologicalferment,financialvolatility,andothersourcesofdisruption.

Deepuncertaintyisthetypeofoperatingenvironmentthen-U.S.SecretaryofDefenseDonaldRumsfeldcharacterizedbytheterm“unknownunknowns.”13Aknownunknowniswhenoneismissingvitalknowledgethatcouldnonethelessbeknown,givenenoughtimeandresources.Forexample,intheBattle

NewYorkerarticlebyJohnNewhousecitingtheexampleofmetalfatiguecausingthecrashoftheBritishdeHavillandCometairlinerinthe1950s.

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ofMidway,bothsidesknewtheenemyfleetexisted,buttheydidnotknowwhere.Incontrast,anunknownunknowniswhenwehaven’teventhoughtofthepossibleevent.

Uncertaineventsdonotalwaysresultinnegativeoutcomes.Alarge,unexpectedeventmightalsobepositive,suchaswhenaconsumer-generatedonlinevideo“goesviral”andcreatesmassivedemandforatoy.However,asanysmallcompanyunabletotakeadvantageofasuddentemporarysurgeindemandknows,positiveshocksrequireagilemanagementandflexibleorganizations.Withuncertaintypresent,theprimaryproblemformanagersandinvestorsisfiguringoutwhattodo.Efficientexecution(howtodoitmostcosteffectively)isdecidedlysecondary.Thatiswhythedynamiccapabilitiesframeworkputsthemanagementpriorityaroundfiguringouthowtodotherightthings;howtodothingsrightisofsecondaryimportance.

Formanagersintheinnovationeconomy,thegoalshouldbetonavigateunexpectedeventswithaminimumofdisruption—andpreferablywithoutresortingtocrisismanagement.Crisismanagementisall-consuminganddeflectsmanagementfromengagingwithconcomitantopportunities.Whatisrequiredforsustainedprofitabilityisthatthebusinessenterprisebebuilttorespondtotheunexpectedbyestablishingandmaintainingflexiblesystems,whicharehallmarksofstrongdynamiccapabilities.

Thereislimitedshort-termfinancialprotectionavailabletoguardagainstsuchuncertainty,ortoembraceunexpectedopportunity.Holdingcashisagoodhedgeagainstunpleasantsurprises;itisaformofself-insuranceagainstuninsurable(negative)uncertaintiesthatabusiness(orindividual)mightface.It’salsogoodtohaveifnewopportunitiessuddenlyemerge.

Managingunderdeepuncertaintycallsforartaswellasscience.Reasonandanalysisareinthetoolkit,butimaginationisalsorequired.Ineffect,navigatingthe

unknowninvolvesimaginingafutureandendeavoringtobuildit.

Thereislimitedshort-termfinancialprotectionavailabletoguardagainstuncertainty,ortoembraceunexpectedopportunity.Holdingcashisagoodhedgeagainstunpleasantsurprises;itisaformofself-insuranceagainstuninsurable(negative)uncertaintiesthatabusiness(orindividual)mightface.It’salsogoodtohaveifnewopportunitiessuddenlyemerge.However,managinguncertaintyrequiresadifferentkindofresourcethatisdeeplyentrepreneurialinnatureandenablesthefirmtodevelopanddeploynon-pricedassets.

VI. 5.2Thecentralityofnon-pricedassets

Mainstreampricetheoryholdsthatwith(perfect)competitionitisimpossibletopurchasesomethingforlessthanit’sworthorforlessthanthelong-termcostsofproducingit.However,andwithoutappealingtomonopolytheory,itisoftenpossibletoacquiresomethingforlessthanit’sworthtothebuyeriftheacquiringfirmhassuperiorinformationorownsrelatedspecificcomplementaryassetsforwhichthereisnoestablishedmarket.

Infact,moststrategicassetshavenomarketpriceinisolationbecausethevalueofanassetiscontext-dependent.Suchassetsgenerallyyieldtheirfullvaluetotheowneronlywhentheyarecombinedwithothercomplementaryorcospecializedassets.Ifmarketsforisolatedstrategicassetsexistatall,theyaregenerallythin.

Itiswellunderstoodthatthepricesystem’snormalassetallocationroleisunlikelytooccurproperlywhenassetvaluesdependonidiosyncraticcombinations.Aneconomicimplicationofthisisthatinputorfactormarketsarenotfullyefficient,andthefactormarkets

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willnotservetheircoordinatingfunction.Theentrepreneurialmanager,nottheWalrasianarbitrageur,achievesthemicro-levelcoordinationonwhichtheeconomydepends.Andthemarketinefficiencyopenstheway,iftheentrepreneurhascorrectlysensedandseizedthebusinessenvironment,forsupernormalprofits—notfromarbitragebutfrominnovationand/orsuperioracumen.

a)Coordination,integration,andinnovationAsnotedearlier,technologicalandinnovationalcomplementaritiesimposecoordination,marketdesign,andcontrolchallenges.Alignmentofactivitieswithinfirmsisrequired.Alignmentamongfirmsisalsonecessarywherecertaintypesofcomplementaritiesexist.14TheseexternalalignmentswereraiseddecadesagoatthemostgenerallevelbyBoulding(1956),thenspecificallybyMalmgren(1961)andRichardson(1972).Thereafter,theywereechoedbyWilliamson(1975),remarkeduponbyTeece(1984,1990),exploredempiricallytoalimiteddegreebyArmourandTeece(1980)andHelfatandTeece(1987),emphasizedinaverticalrelationtogeneral-purposetechnologiesbyBresnahanandTrajtenberg(1995)andHelpman(1998),butneverfullyexploredordevelopedbyeconomistsormanagementscholars.Theeconomicsliteraturetendstoassumethat,inthemain,upstreamanddownstreaminvestmentexpectationswillconverge,whichseemsunlikelygiventheproprietary

14Technologicalcomplementaritiesarelargelyabsentfromeconomicanalysis.Infact,theycompletelyvitiatetheconceptofaproductionfunction,whichassumesthatafixedlistofinputsisusedtopracticeatechnologyknowntoallfirms.Inreality,productionfunctions,evenintheabsenceofamajorinnovation,areoftenfirm-specificandquiteproprietary.Schumpeter(1934)observednearlyacenturyagothattheveryessenceofinnovationistypically“newcombinations.”However,histheorybroughtnogranularitytotheanalysis.Nordidheconsidertheappropriabilityissuesaroundnewcombinationsbecausehismainfocuswasontheabilityofnewproductsandprocessestodisplace

(andhencesecret)natureofmuchoftherequiredinnovationactivity.15

Intheeconomicallysignificantrealmofenablingandgeneral-purposetechnologies,thesealignmentproblemsareparticularlysevere.BresnahanandHelpmanareamongstthefewpointingoutpotentialcontractualandmarketfailureissuesthatmayleadtounder-investment.Withreferencetotheclassofwidelyapplicabletechnologies,Jones(2012:660)notedthatthemainproblemforcapturingvaluebyexploitingtheapplicationofaninnovationinmanydownstreamsectorsis“thefactthatyoucannotidentifytherecombinantpossibilitiesexantemeansthatyoucannoteasilysolvethebargainingprobleminpractice—youcannotintegrateyourwayaroundit.Soinnovationfacesaseriousmarketfailureinthesensethatsociallyprofitableinnovationdoesnotoccur.”Inshort,thereisnomarketmechanism,perhapsnotevenvertical(andhorizontal)integration,thatcanensuresociallyoptimalinnovationandadoptionofgeneral-purposeandenablingtechnologiesthatpermitfurther“addin”innovationbydownstreamimplementers.

Fromamanagerialperspective,thereisasimilarlacunaregarding“alignment.”Someoftheseconcernsareaddressedundertheheadingofbusinessmodelissues(Teece,2010b),leavingittoentrepreneurstodesigncreativeorganizationalarrangementstohelpsolvethecoordinationandassociatedappropriability

existingones.Thisspoketosubstitution,notcomplementarities.15Verticalintegrationcanpartiallymitigatecoordinationproblems.ArmourandTeece(1980)establishedthatR&Dlevelsinthepetroleumindustryweresensitivetotheextentofverticalintegrationinadirectionsuggestingthatintegrationcaneasethecoordinationissueswhennewtechnologyisdevelopedanddeployed.HelfatandTeece(1987)showedthatverticalintegrationreducedrisk,whichcanincludetheuncertaintythataccompaniescommercializationofnewtechnology.

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challenges.Whenthecoordination/integrationchallengesareexternal,privateordering(contractual)solutionsarepossibleinsome—butnotall—cases.

Intangiblesareaparticularlyimportantclassofstrategicassetsforwhichmarketsareunder-developed(Teece,1981,2015).Thisisonlyinpartbecauseofthelimitednatureofthepropertyrightsassignedtothem.Context-dependencyisparticularlyacuteforcertainknowledgeassetssuchastechnologicalcapabilitiesthatcannotbemeaningfullysecuredwithoutacquiringacompanyorbusinessunit,thenfindingawaytoretainkeypersonnel.Evenifpricesdidreflectallinformation,thethin-marketphenomenonreferencedherewouldstillresultinwidebandsfor“competitive”priceswhenfirmsareheterogeneousandproductsaredifferentiated.Thisisthesetupimplicitlyadoptedinthestrategicmanagementliterature(Denrelletal.2003;Rumeltetal.,1991;TeeceandWinter,1984).Modernauctiontheory(e.g.,Klemperer,2002)likewiserecognizesthatassetswillnotachievetheirfullvalueinanauctionifthereisonlyonebuyer.

Economictheoryhasyettoaddressthesepervasivemarketimperfectionsinameaningfulway,particularlyasregardstheirimplicationsforthetheoryofthefirm,theroleofthemanager,andthechallengesassociatedwithinnovation.HintsaboutthesematterscanbefoundinRichardson(1972)andintheliteratureonentrepreneurship(e.g.,Kirzner,1997)andthatongeneral-purposetechnologicalinnovation(BresnahanandTrajtenberg,1995;Helpman,1998;andJones,2012).Whatismissingisanefforttotiethesedisparatethreadsintoatheoryofthefirmthatincludesadistinctiveroleformanagers.Thedynamiccapabilitiesframeworkcanmovethetheoryofthefirminthatdirection.

16Totheextenttheemphasisindynamiccapabilitiesisoncontracts(explicitorimplicit),itislessconcernedwithavoidingopportunismandmoreconcernedwithembracing

b)ThecentralityofmanagerialassetorchestrationBecausethevitalcoordinationandalignmentofassets/resourcesisdifficulttoachievethroughthepricesystem,specialvaluecanaccruefromowningandutilizingthecapabilityofachievinggoodinternalandexternalalignment.Thisismoreeasilyaccomplishedbymanagersthanbymarkets.AchievingsuchalignmentthroughinternalizationgoesbeyondwhatBarnard(1938)hassuggestedasthefunctionsoftheexecutive.Hiswasalimitedviewofmanagers,withtheirtaskwhittleddowntooneof“cooperativeadaptation”(Williamson,1993).Buildingandassemblingassetsinsidethefirm(asopposedtoaccessingthemthroughaskeinofcontracts)isnotdoneprimarilytoguardagainstopportunismandrecontractinghazards,althoughinsomecasesthatmaybeimportant.Rather,itisdonetoachieveeconomiesofscopeandappropriabilitybenefits,whichgoesfarbeyondtheconventionaleconomiclogicofminimizingWilliamsoniantransactioncosts.Thisalignmentprocesshasincentiveandorganizationalculturedimensions,too.Itismeaningfulthatthebasicunitofanalysisfordynamiccapabilitiesisnotthetransaction(asintransactionscosteconomics)buttheentirefirm.16

Incapabilities-basedtheoriesofthefirm,theconceptofcospecializationbetweenoramongassetsisparticularlyimportant(Teece,1986).Assetsthatarecospecializedneedtobeemployedinconjunctionwitheachother,usuallyinsidethefirm(Teece,1980a).

Merelyputtingtwobusinessunitsordepartmentsundercommonownershipandcommongovernanceneednotbringabout“integration”inthesenseofachievingfullalignmentandcooperation.Williamsonidentifiescommunicationdistortions,internalprocurementhazards,internalexpansionproclivities,

opportunity.However,thereisalsoconsiderableemphasisonproduction,learning,andinnovation.

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andprogrampersistencebecause“shiftingtheincrementaltransactionfromthemarkettothefirmgenerallyresultsingreaterbudget-basedsupports,whenceverticalintegrationgivesrisetopersistencetendencies”(Williamson,1975:122).Hisconcludingcommentisthat:

althoughmarketfailureconstitutesapresumptivebasisforinternalizingtransactions,the“defects”associatedwithmarketexchangemayneedtoexceedanontrivialthresholdbeforeinternalorganizationoffersaclearcostadvantage.(ibid.:130)

Onewayortheother,“integration”(whetherwithinafirmoramongstfirms)isnecessaryforlong-termsurvival.Successfulfunctionalintegrationcanbetremendouslyhard,especiallyincontrastwithdisaggregation,whichisoftensimpletoaccomplish.Growthwillalwaysinvolvemoreworkonintegration(whichmaybeonereasonwhymanymanagerspreferlowgrowth).Theentrepreneurialtaskofimplementingvalue-enhancing“newcombinations”inherentlyrequiressomemeasureoffunctionalintegration.Itisnotjustacost-basedcalculus.Thesameistruefornewbusinessmodelsandtheintroductionofnewcapabilities.Thechallengeoffunctionalintegrationislessinsmallercompanies.TheCEO/foundercanusepersonalinfluencetohelpbringitabout.Asorganizationsbecomelarger,theCEOmustworkthroughotherstocommunicategoals,motivateemployees,andpropagatetheorganizationalculturethatunderpinsgoodalignment.AsentrepreneurPeterThielhasnoted,thisishardtodo;buthecreditshisfellowPayPalco-founder,ElonMusk,withthesecapabilities.WithreferencetoMusk’sTeslaandSpaceXventures,Thielhassaidthat“whatwasreallyimpressivewasintegratingallthesepiecestogether,”andthatthis“isactuallydonesurprisinglylittletodayand...whenpeoplecanpullitoff,isveryvaluable”(Thiel,2014).

Inthedynamiccapabilitiesframework,ratherthanthesingle-mindedpursuitofcostminimization,the

distinctiveroleofthe(entrepreneurial)manageristhis“orchestration”ofcospecializedassetsandofbusinessactivitytoachievevalue-creatingandvalue-capturingalignment.Performedastutelyandproactively,suchorchestrationcan:(1)keepcospecializedassets(andpeople)invalue-creatingalignment,(2)identifynewcospecializedassetstobedevelopedthroughtheinvestmentprocess,and(3)divestorrundowncospecializedassetsthatnolongeryieldspecialvalue.Thesegoalscannotbereadilyachievedthroughcontractingmechanismsinpartbecauseofdynamictransactioncosts(thecostsofnegotiating,etc.)butalsobecausetheremaynotbeacompetententitytobuildor“supply”theassetsthatareneeded.Inshort,capabilitiesmustoftenbebuilt,theycannotbebought,andthereislimitedutilityinlabelingthisconundrumasatransactionscostproblem.

Ratherthanstressingopportunism(althoughopportunismsurelyexistsandmustbeguardedagainst),theemphasisindynamiccapabilitiesisonbuildingspecializedassets(thatcannotbebought)andonchangeprocesses(tokeeptheenterprisealignedwithitsbusinessenvironment).Theseprocessesinclude,researchanddevelopment,remoldingthebusinessarchitecture,assetselection,andassetorchestration.Indynamiccapabilities,“smallnumbers”bargainingisatthecore,asinWilliamson(1975).However,theemphasisindynamiccapabilitiesisnotjustonprotectingvaluefromrecontractinghazards;it’salsooncreatingtheassetsthat,intransactioncosteconomics,becometheobjectofrentappropriationefforts.

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VII. 5.3Towarda(capability-based)theoryofheterogeneousfirms

a)IntroductionIntraindustryheterogeneityhasrootsinbothdemand-andsupply-sidefactors.Differencesamongfirmsoftenreflectthefactthatfirmstargetdifferentcustomersegmentswithdifferentneeds.Thus,inautos,VolkswagencompetesfordifferentcustomersthanRolls-Royce,andthisrequiresdifferentproductiontechnologiesanddifferentmarketingandsalesmethods.Foranynumberofreasons,firmsmayoptfordifferenttechnologicalandorganizationalapproaches,usedifferentbusinessmodels,andchoosedifferentstrategies—evenwhenthefirmsarepursuingthesameorsimilarmarketsegments.Such(strategic)decisionsbymanagersestablishdifferentpathways,leadingtointerfirmheterogeneity.

Deepuncertaintyalsoimpactsdecisionmaking.Technologicaluncertaintyrendersdecisionsrelatingtoinnovationcomplex,anddifferentfirmsmakedifferentdecisionsbecauseofhoweachmanagementteamreadsthesituationdifferently(Rosenberg,1982;Teece,Peteraf,Leih,2016).

Asfirmsinnovate,recombineassets,andcompete,theycreateeconomicdynamismanddisequilibrium.17Asopposedtomanyothertypesofinvestments,innovationrequiresrobust“animalspirits”becausethe

17Thecapabilitiesframework,whileantitheticaltotraditionalproduction-functionviewsofthefirm,isnottobeplacedinstrongoppositiontoallmainstreameconomictheoriesofthefirm.Theframeworkincorporates,butisnotanimated,bytransactioncostorcontractualconcerns.Whileitisnotblindtoagencycosts,theseareseenasofsecondaryimportancebecausethedynamiccapabilitiesframeworkis

bestpathisoftenunclear,outcomesareuncertain,andpayoffshardtocalibrate.

Thedynamiccapabilitiesframeworkthusrecognizesthedistinctiveroleofmanagersinassetorchestrationandrecombination.Inendeavoringtobuildatheoryofthefirmwithoutfullyacknowledgingtheeconomicimportanceofinternallymanagedcoordination,Williamson,Jensen,andothershavedeflectedattentionawayfromtheimportantrolethebusinessenterprise,ledbyentrepreneursandmanagers,playsinallocatingresourcestoexpandtheexistingsetofeconomicpossibilities.Coordinationisalsocrucialfortheinitialidentificationoftheseopportunities.Becausethemarketforinformation/knowledgeaboutnewopportunities(Aroraetal.,2001,GansandStern,2010;Teece,1981)isn’twelldeveloped,entrepreneursandmanagersmustbuildorganizationalcapabilitiesinsidebusinessesfirmstoassistinknowledgecreationandknowledgecapture.Theyoftendosoindistinctways,generatingheterogeneity(Nelson,1991).

b)Sensing,seizing,andtransformingThesensing,seizing,andtransformingcapabilitiesofmanagersandtheirorganizationsbringlearningandleadershipontothestage.Mostimportantlyforacompletetheoryofthefirm,theyarethecriticalfactorsthatdistinguishbetweenwhatcanbedoneinsidethefirmasopposedtowhatispossibleunderasystemofpurecontracts.

‘Sensing’isaninherentlyentrepreneurialsetofcapabilitiesthatinvolvesexploringtechnologicalopportunities,probingmarketsandlisteningtocustomers,alongwithscanningtheotherelementsof

focusedmoreonopportunitythanonopportunism.Managerialdiscretion,harnessedastutely,isseenmoreasadesirablecomplementtofirminnovationandgrowthratherthanasasignificantriskfactorthatoughttodriveorganizationaldesignandfinancialstructure.Itenablesassetorchestration,whichsolvesfundamentalmarketfailureproblems.

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thebusinessecosystem.Itrequiresmanagementtobuildandtesthypothesesaboutmarketandtechnologicalevolution,includingtherecognitionoflatentdemand.Theworldwasn’tclamoringforacoffeehouseoneverycorner,butStarbucks,undertheguidanceofHowardSchultz,recognizedandthensuccessfullydevelopedandexploitedthepotentialnewmarket.Asthisexampleimplies,sensingrequiresmanagerialinsightandvision—orananalyticalprocessembeddedintheenterprisethatcanserveasaproxyforit.Sensingbenefitsfromtheapplicationofdataanalyticstoreal-timemarketdatatospottrends,anomaliesandpatterns.Theabilitytosensedifferentwaysofdoingthingsistheprecursortochoosingamongthem.

Onceopportunitiesaresensed,choicesmustbemade,andinvestmentfollows.Thestructureandassetsoftheorganizationhelpshapethechoicesmade.‘Seizing’includesimplementingthechoiceofbusinessmodeltosatisfycustomers,shapemarketsandmarketoutcomes,andcapturevalue.Largecashbalancesprovidethefinancialflexibilitythataidsdynamiccapabilities.Readyaccesstoexternalcapitalandtoptalenthelps.Employeemotivationandculturalalignmentisvital.Goodincentivedesignisanecessarybutnotsufficientconditionforsuperiorperformanceinthisarea.Strongrelationshipsmustalsobeforgedexternallywithsuppliers,complementorsandcustomers,withtheboundariesofthefirmdrawntoavoid(oratleastlimit)thelossofprofitstotheownerofanexternal‘bottleneck’asset(Teece,1986).Cooperationisoftenpartoftheecosystemoccupiedbyfirmswithstrongdynamiccapabilities.

Sensingandseizingaresimilartoexplorationandexploitation,twoactivitiesdiscussedintheorganizationalbehaviorliteratureaspotentiallyincompatibleinsideasingleorganization(March,1991).Exploration(e.g.,researchonapotentially

18ThissectionisbasedonTeece,Peteraf,andLeih(2016).

disruptivetechnology)hasalongertimehorizonandgreateruncertaintythanexploitation(e.g.,sellingmatureproducts).Thetwotypesofactivitiesrequiredifferentmanagementstyles;onesolutionisan"ambidextrousorganization"wheretwoseparatesubunitswithdifferentculturesarelinkedbysharedcompany-widevaluesandseniormanagerswithabroadview(O'ReillyandTushman,2004,2016).Butthetensionsbetweensubunitsmuststillbeastutelymanagedsothattheintegratedstructurereapsthefulllearningbenefits.

The‘Transforming’capabilitiesthatrealigntheenterprise’sresourcesareneededmostobviouslywhenradicalnewopportunitiesaretobeaddressed.Buttheyarealsoneededperiodicallytosoftentherigiditiesthatdevelopovertimefromassetaccumulation,standardoperatingproceduresandinsidermisappropriationofrentstreams.Afirm’sassetsmustalsobekeptinstrategicalignmentvis-à-visitsecosystem.Complementaritiesneedtobeconstantlymanagedandreconfiguredasnecessarytoachieveevolutionaryfitness,limitinglossofvalueintheeventthatdemandshiftsinawaythatfavorsexternalcomplements.

c)Theeconomicsoforganizationalagility:normativeelements18

Thedynamiccapabilitiesframeworkindicatesasetofprinciplesthatentrepreneurialmanagersshouldandusuallydounderstand.Inparticular,managersmustrecognizethatthepursuitofagilityrequiressensing,seizing,andtransformingandoftenputsordinaryanddynamiccapabilitiesinconflict.Observersnotethat“thecrueljokeisthatinattemptingtopreservetheirsourceofadvantage,organizationscanovercommittoinstitutionalization,makingthemmoreinertandvulnerabletoenvironmentalshifts”(Worley,Williams,andLawler,2014).Itisofgreat

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importancetounderstandwhencompanies(inadvertentlyordeliberately)overcommittowoodenstructures,andwheremaintainingandenhancingagilityoughttobeamanagerialpriority.

Achievingorganizationalagilityofteninvolvessacrificingtechnicalefficiencies.Ifnotforthistradeoff,organizationalagilitywouldnotbesohardtoachieve,andordinaryanddynamiccapabilitieswouldalwaysbeadditive.Becauseofthesecostsandtradeoffs,itisgenerallybesttoshieldtheorganizationthroughinsurance/hedgingwhenthechallengeismerelytomanagerisk.Thisisbecauseinsurance/hedgingandtheinstallationofriskmanagementproceduresandprotocolsarelessdisruptiveofoperations,andcanreducetheamountofadjustmentsandadaptationtheorganizationneedstomaketoremaincompetitive.

Thetradeoffbetweenagilityandefficiencyisonlysometimesrecognizedinthefieldofeconomics(e.g.,Stigler,1939).Ithaslikewisereceivedinsufficientattentioninthefieldofstrategicmanagementandisalmostnevermentionedinorganizationaltheory,withthenotableexceptionoftheworkonorganizationalambidexterity,mentionedearlier,byMichaelTushmanandcolleaguesO’ReillyandBenner(e.g.,TushmanandO’Reilly,1996;BennerandTushman,2003).Ambidexterityisadynamiccapability(O’ReillyandTushman,2008).

Outsidetheambidexterityliterature,whichcapturessome,butnotall,aspectsofagility,onlyverylimitedattemptshavebeenmadetoofferprescriptiveadvicetomanagersregardinghowtonegotiatetheagility-efficiencytradeoff.Evenwhenobserversdefineagilityas“ahigher-orderdynamiccapabilitythatisbuiltovertime”(DozandKosonen,2008),theydonotusuallyconsidertradeoffs.The

19Theconceptofhigh-velocitymarketsissimilar(BourgeoisandEisenhardt,1988).Theseideasarealsocapturedinone

followingaresomerelevantprinciplesthatarederivedfromand/orareconsistentwiththedynamiccapabilitiesframework:

1) Riskcanandshouldbemanageddifferentlyfromuncertainty.

2) Thefirsttaskinmanagingthosebusinessenterprisescompetinginenvironmentsexposedtoperturbationanddisruptionistodeterminewhetherthesourceofchangeisprimarilyriskorprimarilyuncertainty.

3) Uncertaintyinthebusinessenvironmentmanifestsitselfinunpredictableturbulence,disruption,andhypercompetition.

4) Moreflexibleplantsandequipmentcanenablethefirmtodealwithfrequentchangesintherateofproduction.

5) Notallbusinessenvironmentsfacestrongdynamiccompetitiongeneratingdeepuncertaintyatalltimes.

6) Relativecalmallowsforformsof“businessasusual,”eventhoughtheorganizationmustremainvigilantandbereadyforrapidchangewhenneeded.

7) Thenetbenefits(i.e.,benefitsminuscosts)oforganizationalagilityincreasewiththedegreeofuncertaintyintheorganization’scompetitiveenvironment.19

8) Tobettermanagedeepuncertainty,businessfirmsneedtoquicklygenerateand“test”a(novel)hypothesisaboutwhatisgoingoninthebusinessenvironment.

9) Strongdynamiccapabilitiescanyieldorganizationalagilitywhileminimizingthecostofachievingaparticularleveloforganizationalagility,therebyallowingmanagementtoachieveamorefavorable

oftheconceptsofnext-generationcompetition(Teece,2012).

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tradeoffbetweenagilityandefficiency.10) Transformationishardforestablished

enterprisesbutrelativelyeasyforstartups.

Theaboveprinciplesarederivedfrom(orareatleastconsistentwith)dynamiccapabilitiesthinking.Webelievethatimplementationoftheseprinciplescanbestbedoneunderthesensing,seizing,andtransformingrubrics.Analysisundereachclusterofmicrofoundationscanbenefitfromconsiderationofthese(derived)principles.Putdifferently,sensing,seizing,andtransformingarethreeclustersofdynamiccapabilitiesthatmustbebuilttoachieveevolutionaryfitness.Whencoupledwithstrategy,eachhelpsachievejudiciouslevelsofagility.

d.AgilityandstrategyNomatterhowastutelyentrepreneurialmanagementcopeswithriskanduncertainty,howeffectivelyitdiagnoseswhat’shappeninginthemarketplace,orhowwellitmanagestheflexibility/efficiencytradeoff,allisfornaughtiftheseactivitiesarenotalignedwithagoodstrategy.Strongdynamiccapabilitiesallowacompanyto“rollwiththepunches”andtapintonewopportunities.However,underlyingagilityhasopportunitycostsandshouldonlybebuiltforworthwhilepurposes.Theseissuesimplicatestrategy.

Theeffectivenessofevenstrongdynamiccapabilitiescanbecompromisedbypoorstrategyandpoorstrategicleadership.Asnotedelsewhere,thegreatertheuncertaintyanddynamisminthebusinessenvironmentandthegreatertheneedfororganizationalagility,themorecriticalgoodstrategy,entrepreneurialmanagement,andstrongdynamiccapabilitiesbecomeforthefirm’sgrowthandfinancialperformance(Teece,2014).

20The82ndAirborneand75thRangerregimentarethebestexamplesofrapiddeployment

Analogiesoutsideofbusinessmakethisapparent.Inboxing,theprizefightermuststayagileand“keepuponhistoes,”readytododgethenextblowfromanadversary,orbetterstill,tostrategicallyplaceone.Agilityandstrategyworkintandem.Insomecases,agilitywillbesacrificedtoaidstrategy,asinthecaseofcommitmentstoproductioncapacity.

Thefactthatreducingagilityissometimesdesirablespeakstotheimportanceofbuildingstrategyintoagilityframeworks,whichthedynamiccapabilitiesframeworkrequires.Agilitydoesnotalwayscreateorpreservevalue.Forexample,adecisionimplies(orsignals)commitmentwhensignificantirreversibilitiesoccur(i.e.,thereisnolow-costwayofgoingback).Clearly,strategicchoicesandorganizationaldesignsneedtobemanagedtogether,andmoreagility,evenputtingcosttooneside,isnotalwaysbetter.

Inthecontextofwarfare,agilityisavaluableforcecharacteristic.HencethejustificationforthesignificantinvestmentsmadeintheUnitedStatesinSpecialForcesandrapiddeploymentforces.20Suchforcestypicallyconsistofelitemilitaryunitsthatareusuallybettertrainedandhaveprioritywithrespecttonewequipment.

Anexcellentexampleoftheinterdependenceofagility(acapability)andstrategyistheBattleofTrafalgar(offCapeTrafalgar,Spain)in1805.ThiswasanavalengagementfoughtbytheBritishRoyalNavyagainstthecombinedFrenchandSpanishfleetsduringtheNapoleonicWars.HistoriansneverfailtogivecredittotheBritishAdmiralLordNelson’sstrategy:engagingtheenemyfleetbydividinghissmallerforceintotwocolumnsdirectedperpendiculartothelargerenemyfleet—acompletebreakfromprevailingtacticalorthodoxy(whichwastoengageparallel,inasingleline).Less

forces.

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frequentlymentionedisthatinpursuingthisstrategy,AdmiralNelsonhopedtoisolatetheenemy’sflagship(leadingtoalackofcoordination)andcreatechaosonthewater.Intheensuingchaos,therewouldnecessarilybeship-to-shipactions,inwhichAdmiralNelson’smoreagileshipsandcrewswouldhaveabetterchance.LordNelsonknewthatthebetterseaman-shipandfasterreloadingspeedsoftheRoyalNavygunnerswouldplayakeyrole.Thestrategywouldfavorhisships’andhiscrew’scapabilitiesovertheirSpanishandFrenchadversaries.Inshort,AdmiralNelson’sstrategyleveragedthemoreagilecapabilityofhisnavalforce.Despiteasmallernumberofships,hewasabletopulloffadecisivevictory.

LordNelson’svictoryatTrafalgarwasnotthroughstrategyalone,whichisoftenassumed,butbymarryingcapabilities(andinparticularagility)andstrategy.Putdifferently,thevalue(andtheneedfor)agilitycannotbecalibratedproperlyabsentconsiderationsofstrategy.Thatistheplacetowhichthedynamiccapabilitiesframeworkleadstheanalyst(andthemanagers).Whenavailable,flexibility/agilitycanbecostlyandwillnotyieldcommensuratebenefitsunlessmarriedtoagoodstrategy.

e.EpilogueonagilityOrganizationalagilityisamuch-toutedattributeandusuallyconsideredvirtuous.However,thereareassociatedcosts,andtheexistingstrategicmanagementliteraturedoesnotexplainwhenagilityisdesirable,thenatureofitsfoundations,andhow,ifatall,itrelatestostrategy.Byviewingagilitywithinthedynamiccapabilitiesframework,weadvancethenotionthatagilityshouldbesoughtonlyinharmonywiththerequirementsofthebusinessenvironmentandwiththefirm’sstrategy.Fortunately,agilityisusuallyunnecessaryinbusinessenvironmentsexposedmerelytorisk.Ontheotherhand,itisessentialwhenconfrontingthe

deepuncertaintyandassociatedthreatsandopportunitiescharacteristicoftoday’sinnovationeconomy.

Thetypeofagilitythat(entrepreneurial)managerschoosetobuildintotheirorganizationsandmaintainshoulddependontheirstrategyandpositioninginthemarketandthedesiretoprepareforbothdownsideandupside.Thatsaid,iffirmshavestrongdynamiccapabilities,theywillbebetteratsensingemergingdevelopments;moreover,theywillachieveagilitywithlesssacrificeofefficiency,alongwithmakingbetteruseofwhateveragilitytheypossess.Thisisbecausetheywill,bydefinition,bebetteratsensing,seizing,andtransforming.

However,oneshouldnotconflateagilityanddynamiccapabilities.Thelatterhasfarmoreelementsand,whenpracticedwell,providestheenterprisegreaterrobustness.Whilefirmswithstrongdynamiccapabilitiesarelikely(iffacingdeepuncertainty)tobeagile,firmsmayperformwellinstableorevenpredictablyvolatile(i.e.,risky)environmentswithouthavingmadecostlyinvestmentsinagility.Thedynamiccapabilitiesframeworkhelpsoneunderstandthecostsandpayoffstoagility,whentobuildagilityinandwhennotto,andwhentosacrificeit.

Thedynamiccapabilitiesframeworkcanhelpguidemanagerswithrespecttowhenandhowtomanageunderdeepuncertainty.Aswehavediscussed,theframeworkisinformedbysystemstheoryandassemblestheelementsneededtodecidewhentoinvestinagilityandwhentorelyonthestandardtoolsofriskmanagement.Traditionalstrategyframeworksarenotonlysilentonsuchmatters,butalsodeflectmanagementfromfocusingonthem.Dynamiccapabilitiespropoundsthat,inregimesofdeepuncertaintysuchasthosewhichcharacterizesectorsoftheeconomyexperiencingrapidchange,managementmustprimetheorganizationfor

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sensing,seizing,andtransforming,andmarrytherightstrategytothefirm’scapacitytobeagile.

Congruencebetweenstrategyandcapabilitiesisparticularlyimportant.Whenthebusinessenvironmentissaturatedwithdeepuncertainty,dynamiccapabilitiesoughttobetheCEO’sleitmotif,asitdelineatespathwaysthatallowescapefromtheagility/efficiencytradeoff.Abductivereasoningandimaginativehypothesisbuildingneedtokickintogearquicklywhenthereisdeepuncertaintyaboutthefuture.Second,whenneeded,agilitycanbeachievedbymultipleorganizationalmodalities.

Finally,whilenotdevelopeddirectly,wenotethatagilitymaysometimesbeafool’serrand;enterprisedeathmayinfactbethebestsolutionifsquanderingresourcestotransformwouldleavestakeholdersworseoff.Becausedynamiccapabilitiesrequirestrategytobecoupledtoagility,onlywheneverythingiscongruentcanvaluebecreatedandcapturedanddurablecompetitiveadvantagerealized.

Thedynamiccapabilitiesframeworkhighlightsinterrelationshipsthatneedtobeunderstoodifmanagersaretobuildandmaintaincompetitiveadvantage.Ithelpssetprioritiesandenablescoherenceandcongruencebetweenstrategy,structure,andthebusinessenvironment.21

21Inthisregard,theframeworkendeavorstorevitalizetheapplicationofgeneralsystemstheoryinmanagement.Oneneeds,asBouldingremindsus,to“notseek...toestablishasingle,self-contained‘generaltheoryofpracticallyeverything’...Suchatheorywouldbealmostwithoutcontent,forwealwayspayforgeneralitybysacrificing

VIII. 5.4Thefoundationsoffirm-levelheterogeneity

Atopmanagementteamdeterminesthepathandcharacterofanorganization.Atanygivendate,thetopmanagementteamofaparticularenterpriseisuniquetoitalone.Whiletheorganizationanditscapabilitiesprovidemanagerswiththerawmaterialrequiredtoperpetuatetheenterprise,itisincumbentontopmanagementtomakethekeydecisionsastowhethertheenterpriseiscurrentlymakingtherightproductsandaddressingtherightmarketsegmentandwhetheritsfutureplansareappropriatelymatchedtoconsumerneedsandtechnologicalandcompetitiveopportunities.Topmanagementmustdevelopconjectures,validatethem,andrealignassetsandcompetencesfornewrequirements,aswellasshapingtheinternalcultureinwhichthegenerationandsharingofknowledgearetotakeplace.Thecombineddynamiccapabilitiesofthemanagersandtheorganizationenabletheenterprisetoprofitablyorchestrateitsresources,competences,andotherassets.

Withthedynamiccapabilitiesframework,Iwouldliketobelievethatweareindeedafewstepsclosertoatrulyfundamentalunderstandingoftheoriginsoffirm-levelheterogeneityandthesourcesofenterprise-levelvaluecreation,capture,anddurablegrowth.Nootherframeworkisasambitiousinitsreach.Understandingtheoriginsoflong-termcashflowgenerationisthedeepestunansweredquestioninmicroeconomicandfinancialtheory.Itisthequestionthatdirectlyandindirectlyanimatesmanagementtheoryand

content,andallwecansayaboutpracticallyeverythingisalmostnothing”(Boulding,1956:197).OnemustneverthelessalwaysremainmindfulofAristotle’sclaimthatknowledgeisderivedfromtheunderstandingofthewholeandnotthatofthesingleparts.

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investmentchoicesandmotivatesthequestforunderstandingthewaysthatenterprisesarefarfrombeinginterchangeableblackboxes.

Asnotedearlier,heterogeneityisalsoimpactedbymarketdemandandtheneedsoftheparticularcustomersegmentsthatabusinessenterprisechoosestotarget.Thebusinessprocessesattheheartofcapabilitiescanbeuniqueandfirm-specific.Theseuniqueprocessesaresometimescalled“signatureprocesses”(Gratton&Ghoshal,2005).22Theyresultfrompastactivities,irreversibleinvestments,andembeddedvaluesthatshapeadistinctorganizationalheritage.Theirbasisinpastmanagerialdecisionstendstomakethemdifficultforcompetitorstoimitate.Soonerorlater,though,iftheyaregood,theywillbecopied.TheToyotaSystemofProduction,whichwaseventuallymatchedbyU.S.automotivefirms,isonesuchexample.However,thereplicabilityofanycomplexprocessissometimesconfoundedbywhatLippmanandRumelt(1982)call“uncertainimitability.”This,alongwithahightacitcomponenttotheunderlyingknowledge,maykeepasignatureprocesseffectivelyproprietaryforquitesometime,providingatleastatemporarysourceofinterfirmheterogeneity.23

6.ImplicationsofCapabilityTheoryforResourceAllocation:x-inefficiencyandd-ineffectivenessTomanyeconomists,thecentralproblemineconomictheoryandinthefieldofeconomicsmoregenerallyistheachievementofefficientresourceallocation.Manytextbooksstillframetheprobleminstatictermssuch22Tobeclear,signatureprocessesarejustoneelementofordinaryanddynamiccapabilities.23Overlongerperiodsoftime,signatureprocessesmaybecomesomewhatimitablebyothers.AsGrattonandGhoshalpointout,suchatransformationoccurred,

as:“thestudyoftheallocationofscarcemeanstosatisfycompetingends.”24Itissometimesformulatedasanissueof“what,how,andforwhom.”Economistsoftenassumethat,iffirmsmaximizeprofits,theywill,absentexternalities,driveeconomy-wideefficiencythroughAdamSmith’sinvisiblehand.AlfredChandler(1977)remindsusthatthevisiblehandofthemanageralsosupportedthepricesystem,althoughhedidn’texplainitinamannerconsistentwitheconomictheory.Thatiswhathasbeenattemptedabovewiththeconceptsofthinmarketsand(managerial)assetorchestration.Themorefundamentaleconomicproblem,perhaps,isabouthowtocreateandsustainbusinessenterprisesthatcaninnovateandchange,therebyaugmentingwhattheeconomycandowithitsavailableresources.Thisisadynamicproblem.

AfterAlfredMarshallandtheAustrianSchool,Leibenstein(1966),asnotedabove,wasoneofthefeweconomiststoexplicitlyrecognizethatmanyfirmsmaynot,infact,achievetechnologicalefficiency,andthattheproductionfunctionmaythereforebedifferentfordifferentfirmsinthesameindustry,evenwhenthereiscompetition.Heproposedtheconceptofx-inefficiency,whichoccurswhenafirmoperatesaboveitscostcurve.X-inefficiencymaderoomforthepossibilitythatmanagers(asopposedtoentrepreneurs)mightmatterineconomictheoryafterall.However,Leibenstein’sx-inefficiencytheory,despitebeingcitedoccasionally,hasnotreallybeenembracedbyeconomists.Ithasarrivedatanenigmaticdeadendintheeconomicsliterature.

Averyrecent,welcomeexceptionisBloometal.(2013),whointerestinglydeclared(consistentwithMarshall)that“managementmatters”(p.40)basedonacontrolledstudyinwhich14Indiantextileplants

eventually,intheautomotiveindustrywithToyota’sleanmanufacturingmodel,knownastheToyotaSystemofProduction.24ThisdefinitioncanbefoundinBecker(1976)andissimilartotreatmentsbyRobbins(1932)andmanyothers.

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weretaughtasetof38well-known(indevelopedcountries)managementpractices,resultingina17%increaseinproductivityinthefirstyear.Theapparentreasonforthefirms’initial(avoidable)inefficiencywasthattheIndianmanagershadeithernotknownaboutthesuperiorpracticesorhadbeenskepticalofwhattheyhadheard.ThisconfirmsbasicAustrianSchoolnotionsaboutimperfectinformation(andinaction)beingubiquitousintheeconomicsystem.

Bloometal.focusonquiteordinaryorganizationalcapabilities,whichareamenabletotransferandtestinginanexperimentalsetting.Inthedynamiccapabilitiesframework,thatismerelythetipoftheicebergintermsofthewaysthatmanagementmatters.

Whilenotcouchedinthelanguageofx-inefficiency,thedynamiccapabilitiesframeworkimplicitlyacceptselementsofthat50-year-oldconcept.Leibensteinandothersattributedx-inefficiencytothelackofadequatecompetition,butjustasimportantispoormanagement,limitedinformation,andweakordinarycapabilities.Strongercompetitorsalonemaynotsolvetheseproblems.

Thedynamiccapabilitiesframeworksuggestsatheoryofthefirmthatnotonlyrecognizesfirmswithx-inefficiency(i.e.,firmswithweakordinarycapabilities,asevidencedbycostsabovethetechnicallyefficientlevel).Italsorecognizesfirmsthatsufferfromwhatmightbecalled“d-ineffectiveness”(i.e.,weakdynamiccapabilities).Infact,Ipositthatmostfirmsared-ineffective,because,atanypointintime,manyarelikelytoproduceaportfolioofproductsnotideallysuitedtocustomerneeds.Moreover,effortstoeliminatex-inefficiencycancaused-ineffectiveness

25Afterbrieflyadoptingtransactioncostsasoneofhistheoreticalframeworks,Chandlerswitchedtocapabilities(Chandler,1992).

throughtheefficiency-innovationtradeoffmentionedearlier.

Strategicmanagementscholarshavelongrecognizedtheproblemofsub-optimalmanagementpracticesthateconomictheoryforthemostpartassumesaway.Asnoted,akeytenetofthefieldofstrategicmanagementisthatnotallfirmswillfollowbestpractice,letalonegenerateandadaptnewpracticeswhichoutclassallothers.Ifafirmisd-effective,itmaynotneedtofollowbestpracticetoremaincompetitive.

Inthedynamiccapabilitiesframework,onlyd-effectivefirmsaredestinedtolast.Developmentsintradeandtechnologyhaveplacedapremiumontheabilityofcompaniestobecomeentrepreneurialandagileathomeandabroad,requiringinturnthatmanagementsenseemergingopportunitiesandthreatsandorganizetoallowandpromoteflexibility,learning,and,ofcourse,innovation.Ordinarycapabilitiesarelesssalientandcanoftenbeoutsourcedtoexpertsuppliersthatachieveeconomiesofscalebyservingmultiplecustomers.Internaloperationalefficiencyisnotenoughforsurvivalandgrowthintoday’sglobaleconomy.Indeed,afocusonefficiencywilllikelydampeninnovation,unlessfirmsareambidextrous(O’ReillyandTushman,2004).

Capabilitytheoryisthustheportmanteauthatallows(strategic)managementtheorytoinformbothadeeperunderstandingofdurablefirm-levelcompetitivenessandtheproperfunctioningoftheeconomicsystem.ItprovideseconomicsubstancetoChandler’sconceptofthevisiblehandwhilehelpingtohighlightinvisiblehand“failures”associatedwithincompletemarkets.25Thisinturnwillleadtobetterunderstandingbypolicymakersofhowthefirmsactuallyoperate,notasmerebundlesofcapital,labor,andtechnology,butratherascomplexorganizations

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thatthriveandwitherbasedinsomemeasureonthe(visiblehand)activitiesofmanagement.

7.PublicPolicyImplicationsDifferencesbetweenparadigmsoffirmbehaviorcanhaveimportantpublicpolicyramifications.Policymakersmuststrivetocarrymultiplemodelsoforganizationalbehaviorinmindastheymakejudgmentsaboutpossibleemergingavenuesofintervention.

Althoughthereissometruthtotheagencytheoryviewthatmanagersstealorwasteshareholderdollarsinvariousways,itcompletelyfailstoprovideanyunderstandingofhowfirmsfirstcreatethevaluethatwaywardmanagers(andboards)thensupposedlydissipateorsteal.Whileithasbeenshownthatcontractingissuesandfearofopportunisticrecontractingbypartiesoutsidethefirmhelpshapetheboundariesofthefirm,transactioncosteconomicsignoresdifferencesinproductioncostsandthevalueofintegratingdiversepoolsoftechnologyandknow-how.Whiletheneoclassicalviewofthefirmasaproductionfunctioncanilluminatecertainissuessurroundingthesupplyanddemandforinputs,itassumesthatmarketsexistratherthanthattheymustfirstbecreated.

Badtheoryproducesbadpolicy;andbad,poorlyinformedpublicpoliciescanweakenaneconomy.Withoutaddingthecapabilitiesapproachtothepolicymaker’stoolkit,government’smayimpedeinnovativechangesintheeconomythatoffermajorgrowthopportunities.Inthissection,Iconsiderthreeareaswhereacapabilitiesapproachcanleadtonon-standardpolicyprescriptions.

IX. 7.1Corporategovernanceandoversight

Regulatoryandlegalframeworksthatrelyoneconomicanalysis,particularlyagencytheory,havesteeredcorporategovernanceawayfromafocusonthefuturehealthoftheorganizationtowardmoreshort-termconcerns.AsGaricano(2000:874)notes,“withafewrecentexceptions,mostpreviouseconomicsliteraturehasequatedthestudyoforganizationswiththestudyofincentiveproblems.”Accordingly,policyframeworkshaveover-emphasizedatleasttwopotentiallymajorsetsof“problems”forcorporatelongevityandgrowth.Oneistheissuesarisingbetweenmanagementandtheboardofdirectors.Theothersetofissuesisbetweenmanagementandshareholders.The“solutions”thathavebeenadoptedconstrainthescopeofmanagementtofullyleveragethecapabilitiesofthefirm,riskinglong-rungrowthinemploymentandoutput.

a) AgencytheoryThemainstream(agency)theoryofthefirmtakesacontraryapproachtothatofthecapabilitiesframework.Inmostlarge,publiclytradedcorporations,ownershipbelongstoamoreorlessfragmentedgroupofshareholders,whileday-to-daycontrolisexercisedbyprofessionalmanagerswhomayormaynotownasignificantnumberofsharesinthefirm.Thisraisesthepossibilitythatmanagerscouldchoosetooperatethefirminwaysthatbenefitthemselvesratherthantheshareholders.

Concernsaboutthepotentialformisallocationofresourcesbynon-ownermanagersdatesbacktoatleasttheworkofBerleandMeans(1932).Inthe1960s,aflurryofbooksbyeconomists,suchasWilliamson(1964),Marris(1964),andBaumol(1967),expandedontheBerleandMeansthesisthatincentivemisalignmentbetweenmanagersandshareholderswasinimicaltoeconomicperformance.

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Inthefinanceliterature,JensenandMeckling(1976)offeredaninfluentialsolutionbasedonthefinancialstructureofthefirm,i.e.,thebalancebetweenthefirm’suseofequity(stock)anddebt(bonds).Theyarguedthatmisalignmentsintheobjectivesandinformationsetsoftheprincipal(owners)andtheagent(managers)imposeagencycostssuchascontractingandmonitoringexpenses.Theirsolutionreliedonatrade-offbetweentheagencycostsofequityfinancing(whichweakenstheincentivesformanagersbyreducingtheirownership)andtheagencycostsofdebt(whichstrengthensincentivesformanagersbutcanleadthemtopursueoverlyriskystrategies).Totalagencycostsareminimizedwhenthemarginalagencycostofadditionaldebtequalsthemarginalagencycostofadditionalequity.Thelogicbehindallsuchagencymodelsisthatmanagementdiscretionmustbelimitedandshareholdervaluemaximized.

Inthedynamiccapabilitiesapproach,theriskofself-interestedbehaviorbymanagersisnotignored,butitisofsecondaryconcernrelativetothefutureprospectsofthefirm.Appropriateincentivesystemsandboardoversightarerecognizedasdesirable.However,themostimportantjoboforganizationaldesignistoempowercreativecontributionsfrommanagersandtocoordinateandalign“experttalent”(Teece,2011).26Long-termshareholderinterestsareservedbystrongdynamiccapabilities.Thetaskoftheboardincompetitivemarketsistohelpmanagerskeepdynamicconsiderationsprioritizedovertechnicalefficiency,asthepursuitofthelattercannotleadto(andcanundermine)long-runcompetitiveadvantageintightselectionenvironments.

Boththeagencyandcapabilityperspectiveshavetheirroletoplay.Owners(i.e.,shareholdersandtheir

26Topmanagementholdsthekeytounlockingthefirm’sinnovationcapabilities.Hittetal.(1996)showedthatcompaniesinwhichmanagersarerewardedprimarilyonperiodicfinancialmeasuresratherthanonanevaluationof

representativesontheboard)mustfindwaystopreventmanagerialexcessandfraudwhileharnessingtheskillofmanagerstobuildcapabilitiesandguidethefirminhypercompetitiveglobalmarkets.

b) BoardoversightOneplacewherepolicymakershaverunafouloftheimperativesofenterprisecapabilitiesisinthedesignofcorporategovernancemechanisms,specificallythecompositionoftheboardofdirectors.IntheCapabilitiesperspective,whatmattersmostistheboard’sroleinverifyingthattopmanagementispursuingacoherentstrategicvisionanddevelopingstrongdynamiccapabilities.Inadditiontothestandardfinancialmonitoringfunction,theboardshouldalsoberesponsibleforrespondingtoevidenceofstrategicmalfeasancebymanagement,i.e.,caseswheretopmanagementismakingpoordecisionswithrespecttothefirm’slong-terminvestments.Positioningforthefuture,notoptimizingforthepresent,oughttobethefocusofattention.

Recentregulatorychanges,suchastheU.S.SarbanesOxleyActof2002,havecreatedgreaterfinancialtransparencyandrequireextremelytightfinancialcontrolsandrigorous—somemightsaypedantic—applicationofaccountingrules.However,thistypeofrigorandoversight,whileconsistentwiththeproblemsasdefinedbyagencytheory,provideslittleprotectionagainststrategicblundersbymanagement.Indeed,byfocusingsomuchboardattentionelsewhere,SarbanesOxleyislikelytoamplifythelikelihoodofsuchblunders.ThenewtechnicalrequirementsofgoodgovernancenowprioritizedinU.S.lawmaybeofonlysecond-orthird-orderimportancerelativetothelargerissuesthattrulygoodgovernancerequires,namely,

theirlong-termstrategicinitiativesarelesslikelytoinvestinR&D(andmorelikelytoacquireotherfirms)evenaftercontrollingforindustry-specificR&Dintensity.

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relentlessfocusoncapabilitydevelopment,innovation,andtransformation.

Complicatingthepictureisthatwhatconstitutes“goodgovernance”may,infact,becontext-dependent.Forexample,insomecircumstances,theseparationoftheCEOandchairmanrolesmaybecounter-productivetotherapidtransformationrequiredtomeetacompetitivethreat,ortodevelopandcommercializeanewtechnologythatismeetingresistancefromcertainpartsofthecompany.Bifurcatedresponsibilitiesanddecisionrightsmightwellcomplicateleadershipissuesandsloworganizationaltransformation.

Manyboardsmaytodayhaveinsufficientstrengthtohelpmanagementproperlyevaluatestrategicalternatives.Boardmemberstypicallylackstafftoconducttheirownanalyses,whichleavesthemreliantonthemselvesandonmanagementfortheirunderstandingofcomplexissues.

InthecontemporarygovernanceenvironmentintheUnitedStatesandEurope(and,toalesserextent,Asia),greaterweighthasbeenputontheneedforboardmemberswhoareindependentofmanagement,butnotonmemberswhounderstandtheindustryenvironmentinwhichthecompanymustcompete.

c) ShareholdervalueInlargepartduetothecurrencyofagencytheory,a“shareholder-centeredideology”hascometodominatethelegal,economic,andbusinessfieldsofmostmajoreconomies—andespeciallyintheUnitedStatesandtheUnitedKingdom(HansmannandKraakman,2001:439;Deakin,2004).Asaconsequence,thereisatrendtowardconvergenceoflegalpractices,boardstructure,securitiesregulation,

27Intheory,agencymodelsarecompatiblewiththelong-term,sociallyefficientmaximizationofenterprisevalue.Inpractice,thelogicofthesemodelshasbeendistortedtorewardshort-termstockmarketactivistswhocajolemanagementtosqueezelargepayoutsthatraisetheshort-

andaccountingmethodologiesthatgovernmajoreventssuchastakeoversdespitenationalvariationssuchastheUnitedKingdom’slegalrequirementforboardstoconsider“employeeinterests”(Conard,1991)andothermanifestationsof“stakeholdervalue”approaches(Kay1998).Theproblem,fromadynamiccapabilitiesperspective,isthatshareholderturnoverishigh,soasingle-mindedfocusonmaximizingshareholdervaluetoooftenleadstoashort-runfocusbybothmanagementandboards.

Corporationsgovernedaccordingtothetenetsofagencytheorymaybe(atleasttheoretically)moreorlessimmunefromself-aggrandizementbymanagers.Buttheconstraintsimposedbyexistingregulationsanddevelopmentsincorporatelawhavealmostcertainlyrestrictedtheabilityofmanagementtoinvestinexistingandnewbusinessestoensurethedevelopmentofcapabilitiesandinnovationtodrivethelong-termhealthofthecompanyandtheeconomy.27

Shareholderprimacybegantoemergeasaguidingprincipleofcorporategovernanceinthe1980s.Itwasmanifestedinmultipleways,includinghostiletakeoversandanincreaseintheroleofstockoptionsinexecutivecompensation(Haberstroh,2002:93).Onefairlyrecentmanifestationfromtheperspectiveofthelong-rungrowthoftheenterpriseisthedrivetoincreasedividendsandbuybacks,bothofwhichraisethevaluetoexisting,butnotnecessarilyfuture,shareholders.Inthe1980s,thelargestcorporationsbeganallocatingalargeshareoftheirincometodividendsandstockrepurchases(Lazonick,2014).Inmanyyears,thecombinedtotalofdividendsandrepurchasesbythelargestcompaniesexceeded75%—andsometimesexceeded100%—oftheirnetincome,

termvalueoftheirshares.Theseactivistsareoftennotinvestorsbutrathertraders,despitethefactthattheycloakthemselvesinthemantleofshareholders.Theyoftenhavelittleifanyinterestinthelong-termhealthofthecompany.

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leavingrelativelylittlemoneyforinvestinginthecompany’sfuture(Lazonick,2014).

Anotheroutgrowthoftheshareholderprimacyviewistheroleofactivistinvestorsinbreakingupcompaniestoreleaseshort-termvaluewhilepotentiallyreducinglong-termpotential.Between2003and2013,theamountundermanagementbyactivisthedgefundsgrewfromlessthan$12billionto$65.5billion(DasandTerlep,2013).ThephenomenonisevenimpactingtherelativelyclosedmarketforcorporatecontrolinJapan(Hamaoetal.,2011).

Companyperformanceinthewakeofshareholderactivismisdifficulttoevaluatebecausealargeshareoftargetcompaniesmergeordelistandothersdivestactivities,leavingareducedassetbaseonwhichtojudgeperformance.Studiesofhedgefundactivismgenerallyfindaanincreaseinearnings(EBITDA/assets)amongtheremainingcompaniesintheyearortwofollowingtheintervention(e.g.Bravetal.,2008).Astudyofmorethan300activistcampaignsbyalltypesofblockholdersthatoccurredbetween2003and2005atU.S.listedfirmsfoundthat,whilethecampaignswereprofitablefortheinvestors,earnings(EBITDAoverassets)generallydeclinedrelativetothoseofamatchedcontrolsampleoffirmsintheyearfollowingtheblockholder’sinitialinvestment(KleinandZur,2011).Thestudyfoundthathedgefundsgenerallypursuedstrategiesofparingcashbalancesbyraisingdividendsorincreasingleverage,whileothertypesof“entrepreneurialactivists”pursuedstrategiesofreducinginvestmentinR&Dand/ornewcapital.28Morethan13%ofthesamplefirmsweremergedoracquiredwithinayearoftheintervention(KleinandZur,2011:219).

28Astudythatlookedonlyathedgefundcampaigns,butcoveringafarlongerperiod(1994-2007)foundthatreturnonassetsgenerallyimprovedinthefollowingfiveyears(Bebchuketal.,2015).Thepaperdoesnotmakedirect

Shareholderactivismrisksreplacingtheknowledgeablejudgmentofthefirm’smanagersandboardwiththeless-informedanalysisofinvestorswithaninterestinmakingaquickprofit.Astudyofhedgefundactivismintheearly2000sfoundthatthefundsheldthesharesoftargetcompaniesforabout20months,whichislong-runfortaxpurposesbutnotintermsofthelifeofacompany(Bravetal.,2008:1732).Itseemshighlylikelythatactivistsareleavingatrailoflostopportunitiesfrominvestmentsskippedforlackofcapitalorexecutivesdistractedbyafocusonreturningcashtoshareholders.Reformsthatwouldbelikelytoimprovetheabilityofmanagementtofocusondevelopingorganizationalcapabilities(whichrequiresastakeholderapproach)ratherthanpayingofforpanderingtoactivistshareholdersincludereducing(short-term)stock-basedpay,limitingtheabilityoffirmstoexecuteopen-marketbuybacks,andrestoringlimitsontheabilityofshareholderstoshapeboards.

X. 7.2Developmentpolicy

Thedynamiccapabilitiesframeworkcouldalsobeusedtoinformpolicywithrespecttoeconomicdevelopment.Consider,forexample,thesuccessesoftheAsian“tiger”economiesandthelacklusteroutcomesinmanyothercountries.Whereastraditionaleconomicdevelopmenttheoristsstressresourceaccumulation(propelledbyhighratesofinvestment),thedynamiccapabilitiesframeworkstressestheimportanceofenterprise-levelentrepreneurship,innovation,learning,andgoodstrategy.

Thisresonateswithemergingtheoriesofdevelopment(LallandTeubal,1998).NelsonandPack(1999)distinguishedbetweenaccumulationandassimilation

comparisonswithotherstudiesorlookatwhethertherecentperiodisdifferentfromtheearlieryearsofthesample.

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theoriesofdevelopment.Theassimilationapproachalignswithdynamiccapabilitiestheoriesofthedevelopmentandgrowthofthebusinessenterprise.Theaccumulationapproachismoreakintotheresource-basedviewofthefirm(Barney,1991).WhenNelsonandPack(1999:434)notedthat“if…onemarshals[inputs]butdoesnotinnovateandlearn,developmentdoesnotfollow,”theyimplicitlyendorsedtheimportanceofcapabilitiesfornationaleconomicdevelopment.

Firmsarethe"engines"ofeconomicdevelopment.Furthermore,asnotedintheintroduction,thereisemergingevidencefromdevelopedeconomiesthatbetter-managedfirmssupporthigherwages.Economicdevelopmentpolicymakersmustthereforeunderstandthedevelopmentalprocessesinsidefirms.Itisuptogovernmenttoprovidethefundamentaleconomicandpoliticalconditionsfavorabletoenterpriseandnationalgrowthincludingafunctionalelectricalandtransportationinfrastructure,macroeconomicstability,non-predatorytaxation,incentivesforsaving,internalandexternalpeace,andrelativelyhighlevelsofliteracy.

Aconsensus,summarizedinaWorldBank(1993)studyofthehigh-growtheconomiesofEastAsia,emergedontheidealinstitutionalbasesforeconomicgrowth:(1)amechanismforbroaddistributionofthebenefitsofgrowth;(2)apowerful,meritocraticbureaucracyinsulatedfromfactionalizedpoliticalandbusinessinfluences;and(3)channelsforsharinginformationbetweenthebureaucracyandtheprivatesector.Althoughsubsequenteventsandlaterreassessments(summarizedinYusuf,2001)havecalledintoquestionseveralaspectsofthe“EastAsianMiracle”andunderlyingpolicies,itisclearthatpublicpolicycanplayamorepositiveornegativeroleinacountry’seconomicdevelopment.

Thescarcityoffirm-specificidiosyncraticassetsandthecomplexityofintegrationandcoordinationprocessesconstrainsthegrowthoffirms.Thesupporting

infrastructureintheeconomyatlargealsomatters,becausethisislikelytoaffectthelocalsupplyofappropriatelyeducatedandtrainedmanagerialandtechnologicalhumanresources.Thegrowthoffirmcapabilitiesiscloselycoupledtotheavailabilityinfactormarketsoftrainedpersonnel.

ItisworthnotingfromtheeconomichistoryoftheUnitedStatesthatitwasonlywiththeemergenceoftherailroad,thetelegraph,andtheprofessionalmanagersrequiredtorunthemthatlarge,innovative,industry-dominatingcompaniessuchasStandardOilandGeneralMotorsemerged.Chandler(1977)labeledthedynamismhechronicledinhisstudyofthelong-rundevelopmentoftheindustrialbusinessenterpriseasaperiodof“managerialcapitalism”(Mason,1958).Theentrepreneurialfunctionsinthedynamiccapabilitiesframeworkarenotconfinedtostart-upsandtoindividualactors.Theyareassociatedwithanewhybrid:entrepreneurialmanagerialcapitalism.

Publicpolicycanhelptoencouragetheimprovementofthelocalpoolofmanagementtalent.Forexample,programsthatsupporteducationinadvancedcountries,periodsofoverseasemployment,andeventualreturntoworkatlocalfirmscan,overtime,raisethequalitylevelofthetalentpool.Incountriesthatalreadyhaveanumberofforeignsubsidiaries,establishingprogramswiththosewhoarewillingtoprovidemanagementtrainingtolocalemployeesisanotherpotentialavenuetoincreasethestockofhumancapital.

Evenwithcompetentmanagement,thepositionsoffirmsinindustrializingeconomiesmaynotinitiallybecompetitiveintheglobalsupplysystem.Nevertheless,asdiscussedinthedynamiccapabilitiesframeworkthesefirmscancatchupbybeingbetteratprocessesandbycarefullychoosingthemarketsinwhichtocompete.ThusmanyfirmsinAsiahavefoundapromisingpathbyactinginitiallyascomplementorstofirmsinadvancedcountries.Thiscouldbeasimplesupplyrelationship,butmultinationalenterprises

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(MNEs)haveanincentivetoinvestresourcesinspurringtheimprovementofcapabilitiesatlocalsuppliersinlow-wagecountriesinordertoreducetheMNE’sowncostswhilemaintainingquality.Mostnotably,localfirmsbecamestrategiccomplementorstoMNEsinmanufacturing(EastAsia)andinsoftwareandservices(India).Theserelationshipsbringhigheremploymentandexportearningstothedevelopingcountry,buttheymaynotinvolvemuchvalueaddedbecauseofthelimitedpowerofthelocalfirmsinglobalsupplychains,wheretheMNE,asownerofthevaluablebottleneckassets,isabletoextractthemajorshareofvalue(Dedricketal.,2010).

Manylocalfirmsinglobalvaluechainsneverdevelopthecapabilitiestocompeteontheirown.Inafewcases,however,localcompaniessuchasAcerinTaiwanandSamsunginKoreasuccessfullygraduatedfromsuppliertocompetitor.Thisrequiredestablishingmanagerialprocessestofacilitatetheabsorptionandintegrationoftechnicalandindustrialknowledgefrompartnerfirmsandothersourceswhiledevelopingcapabilitiestoacquireandapplymarketknowledge,tobuilddistributionandservicenetworks,andtocreateavaluablebrandimage.Strongdynamiccapabilitiesarerequiredtocompeteinglobalindustries.

Inothercases,suppliersinglobalvaluechainscanusetheircapabilitiestoexpandhorizontallytopursuelocalmarketopportunities(HumphreyandSchmitz,2002).Developingcountrieshavearelativelylargeshareofinefficient,poorlymanagedfirms(Bloometal.,2012).Onceaparticularfirmdevelopsexcellenceinmanufacturinginoneindustry,itcanoftenapplyitsoperationalknow-howtoother,import-substitutingindustrieswhereglobalcompetitionislessstrong(AmsdenandHikino,1994).Forthisreason,conglomeratesremainmuchmorecommonindevelopingthaninadvancedeconomies.Largebusinessgroupscanbeasourceofnationaladvantageprovidedthatlocalinstitutionsarestrongenoughto

preventthecorruptionthatoftencomeswithconcentratedwealth.

Acapabilitiesperspectivecanalsobehelpfulindevelopingregionalclusters.Aclusterisageographicconcentrationoffirms,suppliers,andassociatedinstitutionsinaparticularindustry(seePitelisetal.,2006,foranoverview).Suchgroupingscanrealizeagglomerationeconomiesfromphenomenasuchasspecialization,laborpooling,andsharedservices.

Policyinterventionscanassistthedevelopmentofexistingclustersortheemergenceofnewones.Acapabilityinventory,forexample,canrevealgapsinlocalactivities,suchaslegalservicesorITmanagement,thatareraisingcostsorhamperingdevelopment.Promotingtieswithalocaluniversityorothereducationalandtraininginstitutionsintheareacanimproveinnovationorenhancethesupplyofskilledlabor.Reducingadministrativeburdensassociatedwithstartingnewcompaniesandinvestinginnewfacilitiesisalsovital.

8.ConclusionEconomistsrecognizethatthefundamentaleconomicproblemsareabout“what,how,andforwhom.”Textbookeconomicsseesresourceallocationdecisionsasguidedonlybythepricesystem,butmanagerialdecisionsbasedonmorethanjustrelativepricesplayakeyrole,too.Facedwithpervasivedeepuncertainty,differentmanagementteamsseetheworlddifferently,pursuedifferentstrategies,allocateresourcesaccordingly,andbuilddistinctorganizationalcapabilitiesinsidefirms.Somewilldobetterthanothers(Lovalloetal.,2017).Iftheymakemissteps,theycansometimescatchup—particularlyifit’saboutdoingthingsright(the“how”),sincetherewillgenerallybeawaytoachievebest-practiceefficiency.However,itisnotaseasyforabusinesstosolvethe“what”problem—amatterfordynamiccapabilities—

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asthe“how”,whereordinarycapabilitiesaresufficient.

Thecapabilitiesapproachisonlystartingtoreceiveattentionfromscholarsinthefieldofeconomics,despitetheavailabilityofalargeandgrowingtheoreticalandempiricalliteratureinthefieldofstrategicmanagement.Totheextenteconomistshaveexaminedtheconceptinrecentyears,theemphasishasbeenontheordinarycapabilitiesrelevanttomaintainingandimprovingproductivity.Dynamicconsiderationsarelargelyabsentfromthisdiscourse.Mainstreameconomicshasyettofullyembracetherealityofheterogeneous,entrepreneurialfirmscreatingmarkets,developinguniqueanddifferentiatingknowledge,pursuinguniquestrategies,andtransforminginternalstructureandbusinessmodelstomanagedisruptivecompetition.

Coretothecapabilitiesapproachistherecognitionofthebusinessenterpriseasanorganizationwithcapabilitiesandstrategies.Capabilitiesliebehinddistinct,firm-specificproductionactivities.Innovationcapabilitiescreatenewproducts,newprocesses,andnewproductionfunctions.Entrepreneursandmanagersplaycriticalrolesindevelopingandsustainingcapabilities.Ordinarycapabilitiesareaboutbestpractices,canoftenbeboughtor“rented”,anddiffuserelativelyquickly.Dynamiccapabilitiesarehardertodevelop.Theymustbebuiltastheycannotbebought.Whilestrongdynamiccapabilitiesenabletheeffectiveselectionanddeploymentofordinarycapabilities,thestrengtheningofordinarycapabilities,suchasadriveforefficiency,canactuallyunderminedynamiccapabilitiesbyreducingorganizationalagility,unlessskillfullymanaged.

Thedynamiccapabilitiesframeworkcarvesoutauniqueplaceineconomictheoryfortheentrepreneurialmanager,whohashithertohadnoproductiverole.Managersidentifyneededcapabilitiesandhelpbuildorbuythosethataremissing,thenintegrateandorchestratethem.Theyalsochoose

strategiesandmakedecisions—oftenunderdeepuncertainty.Maintainingevolutionaryfitnessrequirestheirpresenceinthetheorybecausethepricesystemalone,evenwhenforwardmarketsarereasonablycomplete,cannotaccountforit.

Becauseofthedominanceofmainstreameconomicsinpublicpolicyanalysis,theabsenceofacapabilitiesperspectivehasledtopolicymyopia.Thecapabilitiesperspectivemaintainsthateconomicgrowthhasmoretodowithtechnologicalandbusinessinnovationthanwitheliminatingadditionalinefficiencies,asimportantasthatisforboostingshort-termprofits.Nationaleconomicgrowthcanbehamstrungifshort-termearnings-per-sharemetricsarecenterstage.What’scriticalforgrowthisforfirmstoinvestinlonger-term,value-enhancingprojects.Ifcorporateboardsareforcedtoworryaboutaudittrailsandaredistractedfromstrategizing,orifCEOswhoinvestforthelongrunarechallengedbyshareholderactivistswithshorttimehorizons,thenthemajorityofshareholdersandotherstakeholderswillsuffer,evenifshort-termtradersgain.

Likewise,iflessdevelopedcountriesfocusoninvestmentfortechnicalefficiencywithoutconsiderationofmarketneedsandthebuildingof(dynamic)managerialcompetences,successwillbelimited.Thereareendlessimplicationsofacapabilitiesapproach,includingthepromiseofanewgenreofmicroeconomicanalysisthatincorporatesamorecompletemodelofthefactorsthatunderliefirmheterogeneity,theinnovativeperformanceoffirms,andproductivitygrowthintheeconomymoregenerally.

Appendix:DeficienciesoftheEstablishedModelsoftheFirmThisappendixcomparesthecapabilitiesviewofthefirmwiththeleadingmodelsofthefirmthatare

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currentlyprominentineconomics.Thethreeconsideredherearetheneoclassicalmodelofthefirm,transactionscosteconomics,andagencytheoreticapproaches.

Neoclassicaleconomicsviewsthefirmasaprofitmaximizingmachine.Somehavecalleditablackbox.Mainstreameconomistshavebeenreluctanttolooktoodeeplyinside.Intheirheavilystylizedmodels,themainroleofmanagementistochooseinputssoastominimizecostswhileproducingthelevelofoutputthatequatesmarginalrevenuewithmarginalcost.Marketsaregenerallyassumedtoexist,althoughdemandmaybeuncertain.Marketpowercanexistandisalmostalwaysseenasdeleterious,evenifithasresultedfrominnovationand/orsuperiorforesight.

Transactioncosteconomics(TCE),closelyassociatedwiththeworkofRonaldCoaseandOliverWilliamson(1975,1985),implicitlyassumesthatproductioncostsarethesamenomatterthegovernancearrangements.Thereislittleefforttolinkthetwo,ortobringininnovation.Coase(1937)wentsofarastoignoretherevenuesideentirely,modelinginternalizationoftransactionsuptothepointwherethemarginalcostofinternalizinganactivityisequaltothemarginalcostofusingthemarketinstead.TCEfocusesinsteadontherelativecostsofintegratingtransactionsinsidethefirmandcontractingfortheminamarket.Internalizationimposescostsbecauseofbureaucraticoverhead,whilemarketcontractscarrycostsrelatedtoassetspecificity,whichraisesthepossibilityofopportunisticrecontracting.

TCEisavariantoftheneoclassicalviewinthatmanagement’sgoalistominimizethesumofproductionandgovernance(transaction)costs.Iftheorganizationallocusofafirm’stransactionscanbearrangedintheorderofthecostdifferencebetweeninternalizationandcontracting,thentransactionsshouldbeinternalizeduptothepointwherethebureaucraticdeadweightofinternalizingthemarginaltransactionisjustequalwiththecostofconductingit

viathemarket.Thislogichasbeenacceptedwithoutseriouscritiquefromwithinthedisciplineforalmostacentury,despitethefactthatitfliesinthefaceofconventionaleconomicanalysisbecause,asnoted,Coasianboundarychoicesaremadestrictlyintermsofcostswithoutconsideringrevenuesorbenefits.Itisunlikely,forexample,thatthedynamiceffectoforganizingknowledge-intensiveactivitieswithinthefirmandacrossamarketinterfaceyieldthesamebenefits.

Theagencytheoryview,whichalsoassumesthatagentswillactopportunisticallyifallowedtodoso,looksatconflictsofinterestwithinandaroundthefirm.Relevantprincipal-agentpairsincludeshareholdersandmanagers,debtholdersandshareholders,andmanagersandemployees.Oneofthemainapplicationsofagencytheoryistocapitalstructure.Inparticular,JensenandMeckling(1976)arguedthattheownershipstructureofthecorporation(insidershareholders,externalshareholders,andbondholders)shouldbeoptimizedbyconsideringtherelatedagencycosts,whichincludemonitoring,bonding,andthelossthatisassumedtoresultfromtheseparationofownershipandmanagementcontrol.Thekeyassumptionthroughoutthisgenreofmodelsisthatmanagerswillmisusecorporatecashbyundertakingnegative-valueprojects,failingtodownsize,orspendingonwastefulR&Dunlessthecashissiphonedofftoservicecorporatedebt.

Anotherclassofagencymodelspushestheproblemdownalevel,withoverspendingarisingfromtheexcessiverequestsofdivisionheadswhoarebetterinformedthanexecutivesaboutthevalueoftheirprojectsandwillchoosethosethatyieldthehighestpersonal(asopposedtoorganizational)benefit(Rumelt,1987;AghionandTirole,1997).Thus,divisionalmanagersaremodeledaslikelytoprovideinadequateormisleadinginformation,whichleadstoinefficientinvestment(e.g.Stein,2002;InderstandKlein,2007;FriebelandRaith,2010).

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Thesemodelsoffirmbehaviorhavemyriadshortcomingsintermsofexplaininghowinnovationandgrowth,therootsofwealthcreation,takeplace.Thedynamiccapabilitiesframeworkmakesastartataddressingthegaps.

XI. A.1Marketstoooftenassumedtobecomplete,andexternalitiestoooftenignored

Atleasttwoofthethreeeconomicmodelsdiscussedabovetendtoassumethatmarketsarerelativelycomplete,eveniftheydon’tnecessarilyfunctionwell.29Theseassumptionsreducetheeconomicproblemtooneofcontract,wheninfactitmaybeamoresevereproblemofmarketexistenceormarketexpansion.

Theproblemstemsinpartfromwhatwasreferredtoearlierasthehyper-rationalequilibriumassumption(TeeceandWinter,1984).Ina“perfect”worldofmarkets(spot,term,future,etc.),thefirmhasfullinformationaboutcompetitors,aboutcomplementorsininvestmentdecisions,andaboutwhatconsumersreallywant.But,inreality,muchofthisinformationisproprietary,tacit,ordiffuse,andthusinaccessible.Thedecisiontoinvestdependsoncapabilitiesforsensingandcalibratingopportunities,developingstrategiestoexploitthemostpromising,andforeseeinghowpotentialcompetitorsandcomplementorswill

29Thecapabilitiesapproachmakesnosuchassumption.Indeed,marketsmayhavetobecreated,asinthecaseofnewproductsandservicesthattapintolatentdemand(e.g.theiPadandAppStore)andwhichrequireafter-salessupportandproducttraining.Thisrequiresthattopmanagementhavethecapabilitiestoidentifyunmetdemand,conceivewaystomeetitprofitably,andcommitresourcestodosowithnocertaintyofacompetitivereturn.Fornewproductcategories,buildinguserawarenessand

respond.Thesearenotcapabilitiesrequiredinaneoclassicalworldofperfectcompetition.Ofcourse,gametheorymodelsofinformationasymmetryexist,buttheyarenotrobust,andafarcryfromthecomplexrealitythatthecapabilitiesapproachendeavorstoaddress.

Oneareawherethisisespeciallyproblematicisthatofcomplementaryinvestment,aproblemflaggedbyMalmgren(1961)andRichardson(1972),remarkeduponbyTeece(1984),exploredmorerecentlyintheverticalcontextbyBresnahanandTrajtenberg(1995),andcommentedonbyJones(2012).

XII. A.2.Existenceoffirmsassumed,entrepreneurssidelined,andmanagersimplicitlyvilified

Theneoclassicalmodelusuallyassumesthatmarketssimplyexistandleadtospontaneousproduction.Agencytheoryalsotakestheexistenceoffirmsasgiven.IntheCoase-Williamsonformulation,firmsarisefrommarketfailure.Itcontraststhecostsformarket-basedarrangementswiththecontrolaffordedbyahierarchicalfirm.Butitisfarfrombeingafullexplanationofwhyfirmsaremorethanthesumof

knowledgeiscritical.ThisiswhatSingerdidgloballytoallowmarketdevelopmentofthesewingmachine.Gillettehaslikewisepromotedtheaestheticbenefitsofremovingmen’sbeardsandofacleanshaveinordertobroadenthemarketforitssafetyrazors.Theneedforsuchcreationandexpansionactivitiesisassumedawayintransaction-basedapproaches,wherethereisalmostalwaysaparty(orcustomer)totransactwithandaknown,existingdemandtosatisfy.

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theirparts.30Andtheassumptionthatfirmsexistallowstheroleofentrepreneursinbuildingfirmstobeignored.

Managersarealsoslighted,eventhoughdifferencesinmanagement(pastandpresent)—andinmanagementdecisions—lieattherootofmostinterfirmheterogeneity.31Inmicroeconomictheory,managershavebeenvirtuallydeniedapositiveroleineconomicperformance,despiteclearevidenceoftheirimportance(AdnerandHelfat,2003).Itisamazingthatthetheoryofthefirmwouldgoforsolongwithscantattentiontotheroleofmanagement.Inthetheoriesdiscussedabove,managersarealmostalwaystreated(ifatall)asboundedly(ifnothyper-)rationalautomatonswithdeepproclivitiestostealfromshareholders.

Inneoclassicaltheory,therolesofentrepreneursandmanagersareoftenstrippedoutbytheassumptionoffullinformationandtheexistenceofacompletesetofmarkets,evenforcontingentclaims.32Agencytheoryrecognizesmanagersonlyinsofarastheywillmisuse

30Thecapabilitiesapproachrecognizesfirmsasrepositoriesoftheproductiveknowledgethatdrivestheeconomy.Inaknowledge-basedtheoryofthefirm,transactions(internalorcontracted)donotjustentailcosts;theyalsodetermine“howtheparties'startingknowledgeendowmentsareblendedandused...[and]howlearningordevelopmentsoccurringduringthecourseoftheworkaretakenintoaccount”(ConnerandPrahalad,1996:484).Becauseknowledgeismorelikelytobefreelysharedandexploitedwithinfirmsthanbetweenthem,theconductofactivitieswithinafirmoftenhasadvantagesoverthemarketthatatransactioncosttheoryignores(Teece,1980a,1982).Insomecases,knowledgeconsiderationswillbemoreprominentthantherisksassociatedwithopportunism,andinothercases,theoppositewillholdtrue.Eveniftransactioncostswerezero,learningandorchestrationfunctionswouldstillneedtobecarriedout.Thefirmisavehicledesignedtodoso.

ormisappropriatecorporatecashifgivenhalfachance.Thisraisesthequestionofwherethewealthinsidefirmscomesfrominthefirstplace,somethingthatagencytheorydoesnot—andcannot—address.33

Economistshavealonghistoryoffailingtoconsiderhowmuchorganizationisnecessarybeforetherearegoodsandservicestoexchangeinmarkets.AdamSmith,inhisfamouspin-makingexample(Smith,1776,I.1.3),didnotexplainhowthepingotinventedandhowtheintegrationandcoordinationofnon-tradedpinsections(e.g.thewire,thehead)tookplaceinsidetheworkshopinordertorealizethefruitsofspecialization.YetmanagementfunctionshadtobeperformedinSmith’spinfactorybecausespecializationwillnotproduceitsbenefitswithoutacoordinatingagent.

Somewhatsurprisingly,economistshavenotdonemuchaboutthislacunainthelasttwohundredyearsevenastheworkcarriedoutbymanagershasbecomeexponentiallymorecomplex.34Thereisoccasionalreferenceto“superiorforesight”bymanagement(e.g.

31Foramorecompletestatementabouthowmanagementfunctionsareobscuredineconomictheory,seeTeeceandWinter(1984).32“Wemaydefinethemanagertobetheindividualwhooverseestheongoingefficiencyofcontinuingprocesses...Theentrepreneur(whetherornotheinfactalsodoublesasamanager)hasadifferentfunction.Itishisjobtolocatenewideasandtoputthemintoeffect....Heistheindividualwhoexerciseswhatinthebusinessliteratureiscalled‘leadership.’Anditishewhoisvirtuallyabsentfromthereceivedtheoryofthefirm.”(Baumol,1968:64–65)33Inthedynamiccapabilitiesframework,managersareexpectedtofulfillentrepreneurialaswellasoperationalroles.WhiletheAustrianSchoolfindsroomfortheentrepreneur,itdoesn’thavemuchroomforthemanager.Incapabilityeconomics,thereisacomplementaryplacefortheentrepreneurandthemanager.Hence,capabilitytheorytakesAustrianeconomicstothenextlogicalstep.34OnenoteworthyexceptionisWalker(1887),whoplaceddifferencesinmanagerialabilityfirmlyatthecenterofhis

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GilbertandNewbery,1982:525),butlittleexplanationofwhatthatmightentail.

ThemanagerisscarcelypresenteveninJohnRoberts’(2004)“modernfirm.”Andevenwhenmanagersarepresentineconomictheory,thefocusofmoderneconomicsandfinanceisonthedistribution,andlesssothecreation,ofthevalue(Jensen,2000).Thisisdespitethefactthattheefficacyofthemarketeconomyflowslessfromthetwintheoremsofwelfareeconomicsandmorefrommanagerialorganizationalcapability,enterprisemanagementresponsiveness,entrepreneurship,andinnovation(Nelson,1981).

Managementisnotjustaboutspecializationandthedivisionoflabor.It’salsoaboutthemoreentrepreneurialtasksofideation,co-creation,andcoordination(assetorchestration).Theintegrationofideasandtaskstocreateorco-createinnovativeproductsandservicesisattheheartofhowfirmscompete.Thisisnotarecentdevelopment,butitisnotyetadequatelyreflectedinmainstreameconomictheory.

However,anempiricaleconomicsliteratureontheeffectsofmanagersandmanagementpracticesonfirm-leveloutcomesisfinallyemerging.BertrandandSchoar(2003)carefullyanalyzedahostoffirm-levelvariablesforasampleofabout500C-levelexecutiveswhohadmovedfromonemajorU.S.companytoanotherbetween1969and1999.Theyfoundsignificantmanagerialfixedeffectsinreturnonassets.Theoperatingvariablesmostassociatedwiththeidentityofanexecutivewereacquisitionanddiversificationdecisions,dividendpolicy,interestcoverage(ameasureofdebtservicerelativetoearnings),andcost-cutting.Mostimportantly,theresultsconfirmcasualobservation—andinvestorbelief—thatcertainindividualexecutivesbringunique

explanationfortheprofitdifferentialbetweencompanies.Unfortunately,hisinsightsseemtohavefoundnopurchaseinthesubsequentliterature.

andpotentiallyvaluablecharacteristicstothefirmstheymanage.

BloomandVanReenen(2007)lookedattheeconomicimpactofmanagementpracticessuchasprocessdocumentationandperformancetrackinginhundredsofmedium-sizefirmsandshowedthattheywerecorrelatedwithproductivitybutfoundawidedispersionofadoptionamongthesamplefirms.Bloometal.(2013)followedthisupwithacontrolledstudyinwhich14Indiantextileplantsweretaughtasetof38well-known(indevelopedcountries)managementpractices,resultingina17%increaseinproductivityinthefirstyear.Theapparentreasonforthefirms’initial(avoidable)inefficiencywasthattheIndianmanagershadeithernotknownaboutthesuperiorpracticesorhadbeenskepticalofwhattheyhadheard.ThisconfirmsbasicAustrianSchoolnotionsaboutimperfectinformation(andinaction)beingubiquitousintheeconomicsystem.

Notonlythesestudiesbutalsologicandsimpleobservationshowthatgoodmanagersplayavitalroleinvaluecreationforshareholdersandotherconstituencies,suchasemployees.Yetagencytheoryhassoblottedoutappreciationofthesecriticalmanagementfunctionsthatthepositiverolesofmanagementareeffectivelyforgotteninmoderntreatmentsofcorporategovernanceandpublicpolicy.

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XIII. A.3Managerial(non-price)resourceallocationsubstantiallyignored

Someeconomistswouldhaveusbelievethatmarketexchangeactivityisthelinchpin,ifnotthesolebasis,ofefficientresourceallocationandwealthcreationintheeconomy.Economists(e.g.Hayek,1945)waxeloquentabouthowwellthemarketdoesthiskindofallocation,andappropriatelyso.35Thefirmisalsosignificantbecauseitisoneplacewheremarketsareparticularlyincomplete.Insidethefirm,thepricesystemmaynotholdsway.

However,wheninnovationandchangearepartoftheeconomy,morethanthepricesystemisneededtoallocatescarceresourcesamongunlimitedwants.Managersandmanagementareneeded,too,inpartbecausekeyassetmarketsaretoothin—ornonexistent.The(neoclassical)economicmodelofmarketexchangetakesforgrantedthatsomehow,somewhere,newgoodsandservicesarebeingdesigned,developed,andproducedbysomemethodthatwillbetechnicallyefficient,conditionalonfactorcosts.

Thepricesystemhaslittlerelevancetotheinternalallocationofresourceswithinfirms.AsexplainedinTeece(1980a,1982,1986)andinHelfatetal.(2007,Chapter2),managers,entrepreneurs,andinnovatorscannotjustleaveituptoahypotheticalmarkettolineupspecificassets,developnewones,andintegratethemintoawell-functioninginnovation,production,andmarketingsystembecausemarketsforhigh-

35HayekandotherAustrianSchooleconomistssuchasvonMisesandKirzneralsomaintainthatpeopledonotallocatemeanstoends;rather,theyconsistentlyseektodiscover

specificity(idiosyncratic)assetsgenerallydon’texist,andiftheydoexisttheyareinvariably“thin.”Toovercomethisproblem,managersbecometheinstrumentsthathelpachievetheshrewd,andoftenhighlycomplex,allocationofcompanyresources.Theygatherinformation,makeassessments,andgivedirectivessothatnon-pricedassetsaredevelopedanddeployedinvalue-enhancingways.Thisistheorchestrationfunctionthatthedynamiccapabilitiesframeworkassignstomanagers.

Asbothatheoreticalandpracticalmatter,howfirmsallocateresourcessothattheyareintheirfirstbestuseisafundamentalquestion.Howfirmsbuild,augment,andmodifytheirresourcebaseandproductivecapabilitiesovertimeisalsoofcriticalimportance.Theseareimportantresourceallocationfunctionsthat(neoclassical)economictheoryignores.

Givenitshistoryofsuccessesinthefaceofuncertainty,managedcoordinationwithinfirmscertainlyseemsjustasremarkableanallocationprocessasthatwhichHayek(1945)observedintheworkingsofthepricesystem.Thus,marketsandintra-firmresourceallocationarenotonlysubstitutes,asCoase(1937)implicitlyclaimed;theyarealsocomplements.Williamson(1999:1106)seemstohaveagreed,notingthat“therelationbetweencompetenceandgovernance[is]bothrivalandcomplementary—morethelatterthantheformer”.

XIV. A.4Intraindustryheterogeneityignored

Aconsequenceoffirms’departurefromcoordinationviathepricesystemisthattheydifferfromeachotherinnumerousways,includingefficiencyand

andcreatenewendsandmeans.Inthisregard,Austrianeconomicsiscompatiblewithdynamiccapabilities;neoclassicaleconomicsisfarlessso.

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innovativeness(Nelson,1991).Mainstreameconomics,includingthethreemodelsofthefirmconsideredinthispaper,shedslittlelightonthesourcesofintraindustryheterogeneity.

Therehavebeenperiodicattemptstoembedfirmheterogeneityinmodelsofeconomicactivity.Iwai(1984),forexample,includedfirmswithdifferentproductioncostsinaSchumpeterianmodelofindustrydynamics.Morerecently,Melitz(2003)introducedacontract-based,heterogeneousfirmsmodelofinternationaltrade.Theheterogeneitywasintroducedbydrawingeachfirm’sproductivityfromaprobabilitydistribution.Firmsstilloptimize,subjecttotheleveloftheirproductivity,andcompeteinexistingmarketswithknowncharacteristics.Firmsmayenterorexitamarket,buttheseevents(particularlyentry)aregenerallyunexplained,apartfromrulethat,atleastintheshort-run,productionisnotworthwhileifpriceislessthanaveragevariablecost.36

Thereisampleempiricalevidencethatprofit-maximizingfirmswillnotnecessarilyachievetechnicalefficiency(Syverson,2011).Asnoted,Leibenstein(1966)introducedtheconceptofx-inefficiency,whichoccurswhenafirmoperatesaboveitscostcurve.EconomistsoftheAustrianSchoolrecognizedthatfirmsmaynotevenachievetechnologicalefficiency.Leibenstein’sx-inefficiencytheorymadeclearthatafullunderstandingoftheeconomyneededtolookmorecloselyatwhyfirmsdiffer.Althoughthechallengewasn’ttakenupatthetime,recentresearchhasstartedtofillintheblank.

36Inthedynamiccapabilitiesframework,bycontrast,interfirmheterogeneityisanaturaloutcome,notanassumption.Becausemanycapabilitiesareidiosyncraticandbuiltonauniqueorganizationalhistoryanduniquebusinessmodeldesigns,theyarenoteasilyimitatedbyotherfirmsthathavedifferenthistoriesandcorporatecultures.Dynamiccapabilitiesareparticularlydistinctivebecausetheyareembeddedtosomeextentinthepersonalitiesandlevel

ThestudiesofmanagementpracticesbyBloomandVanReenen(2007)andBloometal.(2013)confirmedthatmanyfirmsfailtooptimizetheiroperationsforanyofanumberofreasons.Theyshowedthatcompetitionmatters,butsodoesmanagementwithrespecttodevelopingandusingquiteordinarycapabilities.

XV. A.5Firmboundariessetbyincompleteframeworks

Anotheraspectofinterfirmheterogeneityisthatfirmschoosedifferentbusinessmodelsanddifferentboundaries.Inagivenindustry,somemaychoosestrongverticalintegrationwhileotherschoosetocontractoutmostofthenecessaryactivities.Thedifferencescanariseforanynumberofreasons,includingdistinctfirmhistories,disparitiesincoordinationcapabilities,anddifferentappropriabilitystrategies.

Oftheeconomicmodelsunderconsideration,transactioncosteconomicsistheonemostassociatedwithdelineatingtheboundariesofthefirm.Asdescribedabove,transactionsaretobeallocatedbetweenthefirmandthemarketsoastoequatethemarginalcostsofeachmodality.

Theproblemwiththisis,ashintedearlier,thatmarginalbenefitsareignored.Inanycredibleeconomicmodel,firmboundariesneedtobeselected

ofintegrationofthetopmanagementteam(LindenandTeece,2014).Moreover,theimitationofcapabilitiesisoftenconfoundedbywhat“uncertainimitability”(LippmanandRumelt,1982)becauseeventhepeopleinvolvedmaynotfullyunderstandthecomplementaritiesunderlyingaspecificcapability.Hence,capabilities,especiallydynamiccapabilities,arehardtoimitate,allowinginterfirmheterogeneitytopersist(JacobidesandWinter,2012).

47

basednotjustonthebasisoftransactioncostsbutalsoontheneedtocapturevalue(Teece,1986,2006).Inthedynamiccapabilitiesframework,firmboundarychoicesaredefinednotjustbyasetofmake-or-buydecisions.Theyalsorepresentabusinessmodelchoice.Businessmodelstakeintoaccountappropriabilityaswellascostissues.Controloverbottleneckassetsisakeydriver(Teece2006,2010b).Forexample,afirmwithacertaintypeofunpatentableknow-howmaynotbeabletolicenseittopotentialuserswithoutrevealingsomuchthattheusercanemploytheknow-howwithouttakingalicense(Arrow,1962).Thisandothertypesof“marketfailures”candrivefirmstousebusinessmodelsthatemploythetechnologyinternallyratherthanlicensingittoothers.Thisinturnrequiresthattheydeveloporacquirethenecessarycapabilities.

Furthermore,transactioncostanalysisoverlooksproduct-specifictechnologicalconcernsbecausesomecomplementaryactivitieshavemoreneedtobeintegratedthanothers.Forexample,(vertical)integrationismorelikelytobepreferredwhenunstructured(non-modular)technicaldialogueisneededbetweentwostagesofproduction(Monteverde,1995).

Anotherweaknessofthetransaction-focusedtheoryoffirmboundariesisits(implicit)assumptionthatfirmsare(oroughttobe)designedwith(static)efficiencyinmind.Inthedynamiccapabilitiesframework,boundarychoicesneednotbeefficientinatransaction-costsensebecausefirmsdifferintheiruniquehistories,inthequalityoftheirmanagement,intheirinternalorganizationalstructureandflexibility,andintheirreadinesstopursueopportunities.

Inotherwords,firmsneedtochangecontinuallytomaintainevolutionaryfitnessforcompetitioninthemarket.Yetorganizationalchangeisalsolargelymissingfromtheeconomictheoryofthefirm.37While

37Williamson(1985)identifieswhathecallsthe“fundamentaltransformation,”butaclosereadingshows

thereisarecognitionamongorganizationaleconomiststhatchangecanbedifficultduetothepresenceofcomplementaritiesoremployeemindsets(BrynjolfssonandMilgrom,2013),thereisvirtuallynoexplorationoftheprocessesthatleadtotheneedforregulartransformationsofinternalstructuresandscopeofactivities.

XVI. A.6Thetheoryofcomplementsisconfused

Complementsarepervasivethroughouttheeconomicsystem,andparticularlyintechnologydevelopmentandbusinesstransformation.Itiscommonfortwoormoretechnologiestoproducemuchmorewhenpracticedtogether.Thefirststeamtrainsemergedwhenhigh-pressuresteamengineswereyokedtocoalcarsrunningoncoal-mininghandcartrails.ThelaserandthecomputertogetherenabledCDsandDVDsandalsoopticalfiber-basedtelecommunications.Nevertheless,thesecomplementaritiesarenotcapturedadequatelybymostmainstreameconomicmodels.

Absentcomplementarytechnologies,manyproductssimplywon’tgetdevelopedandlaunched.Thiswasthecase,forexample,intheU.S.electricalsupplyindustryattheendofthe19thcentury.Theindustryhadakillerapp—lighting—butwasmiredina“warofthecurrents”betweenalternatinganddirectcurrent,eachofwhichhadcertaindeficiencies.Itwasonlywiththedevelopmentofrotaryconvertersthatonesystem(alternatingcurrent)wasabletodevelopadominantpositionandspurrapiddeployment(David,1992).

Attheheartofeconomicnotionsofcomplementarityistheidea,duetoEdgeworth(1897),thatthemarginalvalueofavariableincreaseswithanothervariable.

thatitisnotaboutorganizationaltransformation,butrathertransformationinacontractingparty’scompetitiveposition.

48

Despitethissimplebasis,thereismuchcomplexitytotheconceptofcomplementarity,whichpromptedNobelLaureatePaulSamuelsontosayin1974that:

Thetimeisripeforafresh,modernlookattheconceptofcomplementarity…thelastwordhasnotyetbeensaidonthisancientpreoccupationofliteraryandmathematicaleconomists.Thesimplestthingsareoftenthemostcomplicatedtounderstandfully.(Samuelson,1974:1255)

Theliteratureoncomplementsremainsunderdevelopedandratherconfused.38Economiststendtothinkofcomplementarityintermsofitseffectonfactorpricesoronvaluefromuse(CarlawandLipsey,2002).Innovationstudies(e.g.,RosenbergandFrischtak,1983)lookinsteadattechnologicalrelatednessandtheimpactofnewcombinationsofexistingtechnologies.Economicsneedsastructurethatcanencompassanddifferentiateamongtheseandothervariantsofcomplementarity.

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Table 1: Some Differences Between Ordinary and Dynamic Capabilities

Ordinary(“necessary”)capabilities Dynamiccapabilities

Purpose Technicalefficiencyinbusinessfunctions

Achievingcongruencewithcustomerneedsandtechnological

opportunities

Modeofattainability Buyorbuild(learning) Build(learning)

Tripartiteschema Operate,administrate,andgovern Sense,seize,andtransform

Keyroutines Bestpractices Signature(beyondbestpractice)processes

Managerialemphasis Staticoptimization Entrepreneurialassetorchestration

andleadership

Priority Doingthingsright Doingtherightthings

Imitability Relativelyimitable Relativelyinimitable

Result Technicalfitness(efficiency) Evolutionaryfitness(continuousinnovation)

Source:basedonTeece(2014),Table1

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Table 2: The Interrelation of Dynamic Capabilities and Strategy

Strategykernel Diagnosis Guidingpolicy Coherentaction

Relateddynamiccapabilitiesschema Sensing Seizing/transformation Seizing/transformation

Natureofmanagerialorchestration Entrepreneurial Administrative Leadership

Source:Teece(2014).

Figure1:TheDimensionsofDistanceforTransformation

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Figure2:TheLogicalStructureoftheDynamicCapabilitiesFramework

Source:Teece(2014).