Dynamic Capabilities, Related Paradigms, and Competitive Advantage in the Innovation Economy

DYNAMIC CAPABILITIES, RELATED PARADIGMS,
AND COMPETITIVE ADVANTAGE IN THE
INNOVATION ECONOMY
Professor David J. Teece
Tusher Center for Intellectual Capital Management
Haas School of Business, University of California, Berkeley
*Slides partially based on:
1. D.J. TEECE, “TOWARD A CAPABILITY THEORY OF (INNOVATING) FIRMS: IMPLICATIONS FOR MANAGEMENT AND
POLICY”, CAMBRIDGE JOURNAL OF ECONOMICS, 2017 1 OF 28
2. D. TEECE, M. PETERAF, S. LEIH, “DYNAMIC CAPABILITIES & ORGANIZATIONAL AGILITY: RISK, UNCERTAINTY, &
STRATEGY IN THE INNOVATION ECONOMY”, CALIFORNIA MANAGEMENT REVIEW, VOL.58, NO.54 (SUMMER 2016)..
3. D. Teece, “A Capability Theory of the Firm: An Economics & (Strategic) Management Perspective”,
New Zealand Economic Papers (NZEP), (forthcoming).
Copyright D.Teece 2017
1

TABLE OF CONTENTS
1. Great minds tell us much is wrong with economic theory
2. The data tells us our theories are wanting
3. Back to the beginnings: antecedent from classical
economists
4. The field of strategic management to fill the void:
resources and capabilities
5. The distinction between risk and uncertainty is important
to theory development
6. The capabilities framework: general
7. Capabilities and strategy
8. Enhancing/modifying capabilities and closing capability
gaps
9. The Dynamic Capabilities Framework: Unfinished business
10. Dynamic Capabilities and related paradigms
Copyright D.Teece 2017 2

I. GREAT MINDS TELL US MUCH IS
WRONG WITH ECONOMIC
THEORY: WE NEED A
CAPABILITIES PERSPECTIVE

“The proximate cause [of
differences in the wealth of
nations] lies, for the most part,
in the capabilities of firms”
-John Sutton, London Business School, 2012

Three Nobel Laureate economists
express deep concern about the
current state of economics
 “Year after year economic theorists continue to produce
scores of mathematical models and to explore in great
detail their formal properties ... without being able to
advance, in any perceptible way a systematic
understanding of the structure and the operations of a
real economic system.” (Wassily Leontief, 1982: 107)
 “Economics as currently presented in textbooks and
taught in the classroom does not have much to do with
business management”, which has “severely damaged
both the business community and the academic
discipline” (Ronald Coase, 2012)
5

 Nobel Laureate Ronald Coase (1988) also pointed out that:
 It is not enough for a theory of the firm to merely explain
firm boundaries
 A proper theory of the firm needs to explain why firms
develop capabilities and have different (heterogeneous)
costs
Coase & capabilities theory

Nobel Laureate Amartya Sen also
highlights capabilities
 Grapples with capabilities, but his focus is on what can be called
ordinary capabilities, in contrast to the dynamic capabilities that
are the main focus here
 Capability framework is articulated more at the level of the
individual, not that of the organization
 Capabilities are seen as the fulcrum for leveraging tangible
resources into human achievement
 Recognized that individuals can differ greatly in their abilities to
convert a given set of resources into outputs

Economist Paul Romer’s Biting
Critique:
 Economics is suffering from “a general failure mode of a
scientific field that relies on mathematical theory”,
which includes “disregard for and disinterest in ideas,
opinions, and work of experts who are not part of the
group” (Romer, forthcoming: 7)
 Romer’s criticism of the pursuit of (false) rigor over
relevance is just as relevant to micro- as to
macroeconomics

Even a US federal judge has keen insights
into business firms consistent with the
strategic management perspective
 A “producer may be the survivor out of active competitors,
merely by virtue of his superior skill, foresight and industry"
(148 F.2d 416 (2d Cir. 1945) at 571).
-Judge Learned Hand

The capability to innovate and change is the
very essence of capitalism, yet it is deeply
underplayed in modern economic theory
 The very essence of capitalism—in fact, the very advantage of
a private enterprise economy over a planned one—is that,
with private enterprise, firms innovate, compete, sometimes
disrupt each other, and sometimes cooperate (Nelson, 1981)
 Theories of the firm that do not put innovation and change
center stage are not in tune with the essence of our economy
or the fundamental managerial challenges of our time

II. THE DATA TELLS US THAT
OUR THEORIES ARE WANTING

12
0
0.05
0.1
0.15
0.2
0.25
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
75th Percentile
25th Percentile
Top and bottom profit margin percentiles indicate
that firms’ performance is becoming more
dispersed
Source: Compustat
Notes:
• Rolling profit margin is defined as EBIT divided
by revenue
• The sample was restricted to firms with $100
million in revenues in at least one of the years
between 1965 and 2014
• Revenue field was considered missing
whenever it was zero or negative
• Industries were defined using manual grouping
by the 2-digit SIC code. Quartiles were
calculated across all industries
• Only years with the minimum number of 20
companies were considered
• Industries included: Multiple
• Annual data derived from the financial
statements of active and inactive North
American publicly traded companies. The
sample was restricted to companies with $100
million in revenues in at least one of the years
between 1965 and 2014
EBIT
Revenue

Economists can no longer claim to
analyze income inequality issues while
relying on black-box models of the firm
 Wage differences are larger between companies than within
them (e.g., Barth et al., 2016; Abowd, McKinney and Zhao,
2017)
 Over two-thirds of the increase in earnings inequality from
1981-2013 can be accounted for by the rising variance of
earnings between firms
 Inter-firm wage inequality has become greater and more
persistent as firms increasingly sort themselves into a small
number of knowledge-intensive companies and a larger pool of
relatively labor-intensive firms.

III. BACK TO THE BEGINNINGS:
ANTECEDENTS FROM THE
CLASSICAL ECONOMISTS

Alfred Marshall (the founder of modern
microeconomics) recognized that management
matters and “adventure” is required
 In Principles, Marshall (1920) recognizes the role of
management in determining enterprise performance
 Managers fall into those “who open up new and improved
methods of business and those who follow beaten tracks.”
 Managers, or “businessmen”, “adventure” or “undertake” the
risks (and uncertainties) of business. They bring together
capital and labor, conduct planning, and superintend to minor
details
 The manager is “the natural leader of men” (Book IV, Chapter
XII, p.173). Marshall notes that good managers are hard to
find, and that management skills tend to atrophy

Frank Knight (1921) hinted at the
need for dynamic capabilities theory
of the firm
 “With uncertainty present, doing things, the actual execution of
activity becomes in a real sense a secondary part of life; the
primary problem or function is deciding what to do and how to do
it” (Knight, 1921:268)
Interpretation: Making the right investments is critical while
optimizing current activities for efficiency is less important.

Lord Keynes (1936) with his appeal to
"animal spirits” was perhaps searching
for a theory of (dynamic) capabilities?
 Was keenly aware of the importance of firm-level investment decisions
and long-term investor expectations for macroeconomic theory
 Invoked “animal spirits” not to signal irrational behavior but to help explain
investment decisions under uncertainty. Investing requires some kind of “leap
of faith” because of the fog of ambiguity around financial outcomes
 Observed that: waiting too long for the future to unfold will often
cripple decision making
 “Most, probably, of our decisions to do something positive, the full
consequences of which will be drawn out over many days to come, can only
be taken as a result of animal spirits—of a spontaneous urge to action rather
than inaction, and not as the outcome of a weighted average of quantitative
benefits multiplied by probabilities... Thus if the animal spirits are dimmed
and the spontaneous optimism falters, .... enterprise will fade and die.”
-Keynes, 1936, p.161
17

Animal spirits foreshadowed “dynamic
capabilities”
 The Keynesian concept of animal spirits is very consistent with
dynamic capabilities
 “Animal spirits”—an ability to envision a positive business
outcome requiring an astute investment path under uncertainty
—and is consistent with strong dynamic capabilities
 Weaker firms and management teams are indecisive, devoid of
dynamic capabilities, and wait too long for greater certainty

Lord Keynes & Jeff Bezos (Amazon) see
eye-to-eye
 Keynes stressed that if human nature felt no temptation to
take a chance and investment had to rely on cold calculation,
there might not be much investment
 Likewise, Jeff Bezos, the CEO/founder of Amazon, noted:
“there are decisions that can be made by analysis … Unfortunately,
there’s this whole other set of decisions that you can’t ultimately boil
down to a math problem” (Deutschman, 2004, p. 57)

IV. THE FIELD OF STRATEGIC
MANAGEMENT TO FILL THE VOID:
RESOURCES & CAPABILITIES

The evolution of strategic management & “research based”
thinking
5 Forces
-industry
attractiveness is
the central
focus
-Entry barriers
critical
-Shielding from
competitors is the
game changer
RBV
-VRIN assets
drive value
creation
- 4 VRIN
traits necessary to
sustain advantage
“Isolating
mechanisms”are
central
Dynamic
Capabilities
-Asset orchestration
& strategy help
drive advantage
-Reshaping
ecosystems & biz
models is critical
Decision making
under deep
uncertainty
Identifying &
bridging capability
gaps
1980s 1990s 2000+
Copyright Teece 2016
21
Deep
Uncertainty
Risk
Planning
-1-5 year
budgets
- Risk control
-Market forecasts
-Limited
competitive
analysis
1960s

 Limited ability of a firm to generate “supernormal” profits over the
long run
 Competitive advantage is often fleeting
 Few firms change and thrive over the long haul: GE, IBM, 3M, Apple…
 My thesis: With deep uncertainty, strong asset orchestration, internally
and externally, coupled with good strategy and the astute assembly of
resources undergirds Dynamic Capabilities which enables supernormal
profits
 Definition of Dynamic Capabilities: “The ability of an organization and its
management to integrate, build, and reconfigure internal and external
competences to address rapidly changing environments”*
 Evolutionary fitness, not best practices, define great firms.
*Teece et al., 1997: 516
The fundamental question in Strategic Management:
How do firms build long-run Competitive Advantage?

Resources: One step towards a capability
theory
 Resources are the tangible and intangible assets, broadly defined,
that the firm can develop and effectively control.
 Resources, include the skills of the firm’s employees, its equipment,
and the collective skills of the organization, generate streams of
services that the firm can deploy
 As theorized by Penrose (1959) a firm at any point in time is likely to
have underemployed resources, including management skills
 A firm with excess resources will only sometimes find it profitable to
monetize those services via product diversification (Teece, 1980a,
1982)
 However, the resource based model (Rumelt, Wernerfelt, Barney, &
Amit), has a core assumption that resources are “inalienable” in the
sense that they are tied to the firm

Dynamic Capabilities Builds on/Accepts Resource
Based View. However:
 The resource view is Ricardian and therefore static
 Each element of VRIN can change over time:
24
Resource-Based Concept Commentary
V= Valuable
R= Rare
I= Imperfectly immitable
N= Non-substitutable
 Bottlenecks can migrate up and down the value
chain, horizontally and laterally, e.g. valued
Computerland’s retail footprint in the 80’s & 90’s
was destroyed by Dell’s direct-to-customer business
model
 Patents can expire, products can be reverse
engineered
 New substitutes are being invented constantly, e.g.
margarine for butter; electric cars for internal
combustion engine cars

 How resources are built, coordinated and managed is
at least as important to competitive success and
survival as the identity of the resources themselves
 Capabilities such as asset orchestration and market
creation (or co-creation) are vital to profitable
“resource” management (Pitelis and Teece, 2010)
 Whereas the resource based framework can explain
competitive advantage for the moment, it cannot
explain it over time because it ignores uncertainty
 Yet, dynamic capabilities requires managers to
understand VRIN ideas: the frameworks are
complements, not substitutes
25
Observations on the resource-based
approach
“DYNAMIC CAPABILITIES: THE RESOURCE BASED APPROACH
ON WHEELS & WITH AN ENGINE”

V. THE DISTINCTION BETWEEN RISK &
UNCERTAINTY IS IMPORTANT TO
THEORY DEVELOPMENT

Alternative futures with known
probabilities & known conditional
probabilities
Pr(DIA)
Pr(CIB)
Risk
C
D E F
prB
Pr(FIB)
Pr(CIA)
prA

28
F1
F?
F?
F?
F?
F?
F? F?
F2
F3
F4
F?
F?
F?
F?
Uncertainty
Don’t know most futures or their probabilities with (unknown
unknowns with probabilities)
F 1-4 are possible futures
F? are undefined futures
F?

Mixed Martial Arts. MMA is a good metaphor
for competition under uncertainty
Chess
Each move is knowable (closed world). The better player almost
always wins. A large but finite number of moves and counter moves.
If the player (e.g. a computer) has unlimited computational powers,
chess is a trivial game as Von Neumann and Morgenstern once
observed
Mixed Martial Arts
Not a closed world… rules more permissive. Striking, grappling,
boxing, kickboxing, Brazilian Jujitsu, Judo, and wresting are all
widely employed
29
MMA is a better metaphor for
the innovation economy than
is chess

The lack of predictability and deep uncertainty in MMA is not unlike
todays interdependent innovation economy.
 Existing “rules” of competition are being changed
 Entirely new “rules” are invented (e.g. cloud computing;
Amazon Prime, internet of things)
 New players constantly emerging (e.g. mobile money, start-
ups versus the banks)
To succeed in this world, managers need to be entrepreneurs,
and entrepreneurs need to be (or find) managers too (e.g. Brin
and Page found Schmidt to be CEO of Google).
30
The innovation economy puts a premium
on entrepreneurial management when
there is deep uncertainty

VI. The capabilities framework-
general

To understand competitive advantage,
don’t confuse ordinary and dynamic
capabilities
Capabilities
Ordinary
(technical efficiency)
Dynamic
(dynamic effectiveness)

Strong “ordinary” (or normal)
Capabilities: Only requires resources to
be used efficiently
 Routines / standard operating procedures are key to ordinary
capabilities
 Ordinary capabilities reflect technical efficiency
 Diffusion of ordinary capabilities to rivals is enabled by
 More information in the public domain
 Better business school training
 Management consultants
 “Best practices” reflect strong ordinary capabilities
 Admittedly, not everyone gets the simple stuff right
33

Best practices don’t suffice
 There is no benefit at being very good at delivering the
“wrong” products
 Best practices alone are generally insufficient to ensure a
firm’s success and survival, except in weak competitive
environments (which are still ubiquitous in less-developed
countries).
 Much of the knowledge behind ordinary capabilities can be
secured through consultants or through a modest investment
in training (Bloom et al., 2013).
34
Being a top performer in productivity is unlikely to
lead to competitive advantage because it only takes a
few firms at the frontier to drive prices down to
competitive levels

35
Lewis Carroll, “Through the Looking Glass”
The Problem:

From ordinary to dynamic capabilities in
autos
 Ordinary: The operations portion of the automobile business
has been thoroughly optimized over many decades, doesn’t
vary much from one automobile company to another, and can be
managed with a focus on repetitive process. It requires little in
the way of creativity, vision or imagination. Almost all car
companies do this very well, and there is little or no
competitive advantage to be gained by “trying even harder”
in procurement, manufacturing or wholesale
 Dynamic: Where the real work of making a car company
successful suddenly turns complex, and where the winners are
separated from the losers, is in the long-cycle product
development process, where short-term day-to-day metrics and
the tabulation of results are meaningless.
 -Bob Lutz, former vice chairman at General Motors, Wall Street Journal, June11, 2011
36

Turbulent
Environment
Risky
Environment
Stable
Environment
Poorly
Managed
Companies
weak
weak
Dynamic
Capabilities
Ordinary
Capabilities
Desired Capabilities
(Ordinary v. Dynamic)
Mix Frontier
Strong
Strong
Deep uncertainty (turbulent environments)
require strong dynamic capabilities:
With stable environments ordinary capabilities are good enough
& the VRIN criterion provides meaningful guidance

38
Capabilities and Tools Required for Stable &
Uncertain Environments are Different
Certainty Risk Uncertainty Ambiguity Chaos/Ignorance
Newer/Tools/Approach
es
Influence Diagrams
Scenario Planning
Peripheral vision
Total Risk
Management
Systems Thinking
Idealized Design
Leigitimation Theory
Honing Institution
Complexity Theory
Cost Benefit Analysis
Net Present Value
Linear Programming
Point Forecasting
Optimization Theory
Utility Theory
Decision Trees
Bayesian Updating
Monte Carlo
Simulation
Portfolio Theory
Stochastic Modeling
Insurance & hedging
Known Unknown Unknowable
Traditional Tools/Approaches
Domain of Ordinary Capabilities
Domain of Dynamic Capabilities

Sensing
Identification of
opportunities &
threats at home
and abroad
Transforming
Continuous renewal
and periodic major
strategic shifts
Seizing
Mobilization of
resources to
deliver value and
shape markets
39
Dynamic capabilities can be thought of
as falling in three categories:

Sensing, Seizing & Transforming Are The Practical
Pillars Of Dynamic Capabilities
40
Firm
Performance
Sensing
Co-creating and
Seizing
Transforming
Perception and
Attention
Problem Solving
and Reasoning
Communication and
Social Cognition
Opportunity
Recognition &
Creation
Strategic
Investment &
Business Model
Design
Asset Alignment &
Overcoming Change
Resistance
Sample
Managerial
Cognitive
Capabilities
Dynamic
Managerial
Capabilities
Potential
Strategic
Impacts
Source: Helfat & Peteraf (2015, p.837)

The ability to foresee future
opportunities and threats… what
Jack Welsh (CEO of GE) once referred
to as the ability to “see around the
corners” It requires good sensing
plus sensemaking
Sensing is the ability to see around
corners

Sensing & Black Swans
 Alert businesses can “discover” the future
ahead of the competition
 The future is bound to surprise us, but we
don’t have to be dumbfounded
-Kenneth Boulding

“Intellect has little to do on the road to discovery. There
comes a leap in consciousness, call it intuition or what you
will, and the solution comes to you, and you don’t know how
or why.”
Albert Einstein
Sensing is akin to discovery of the truth

 Explanations are developed for surprising or
anomalous behavior/phenomenon
 Induction & deduction depend on the past
 Abductive reasoning moves ahead through
“logical leaps of the mind” and uses all
available data in a search for patterns
 Once an abductive hypothesis is established,
data is searched to test the hypothesis,
which in turn spurs original thinking
 Not used to determine if something is true or
false, but to indicate a new path to “deep
truth” about a phenomenon or a situation

Good sensing benefits from “abductive”
reasoning as a way to help sense the
future
44

Logical Implications of Abductive
Reasoning
 If an investment option has a deductive logic, then the options
can only ever reflect thinking that started with a proven
template
 If an option has an inductive logic, then “new” options simply
follow an established template
 Neither inductive or deductive logic allow one to find
fundamentally new knowledge. Abduction digs deeper and
helps create new knowledge
 Management must suppress a tendency to apply known rules;
Abductive reasoning is the handmaiden of sensing

Other tools to improve sensing
• Sometimes sensing is enabled by internal R&D activities
(“search activities”) and internal scenario planning and other
tools to probe the future
• Internal R&D can be complemented (but not displaced) by
crowd-sourcing ideas, or by tapping into ideas of customers
(Von Hippel), supplies and/or other partners
The challenge is to develop a valid hypotheses
about what is going on in the market

Seizing/Asset Orchestration is also core
to dynamic capabilities
“Apple still has strong growth
opportunities because of its ability to
work simultaneously on hardware,
software and services… Apple has the
ability to innovate in all three of these
spheres and create magic… This isn’t
something you can just write a check
for. This is something you build over
decades.”
-Tim Cook, Apple CEO (Taipei Times, February 2013)
47

48
Fig 5: Leadership Undergirding Dynamic Capabilities
Source: Krupp, Steven and Paul J.H. Schoemaker, Winning the Long Game: How Strategic Leaders
Shape the Future, Public Affairs/Perseus, 2014.
Asset orchestration requires many skills

Orchestrating co-specialized assets can
be value creating & value capturing
building blocks
 Building and assembling assets designed specifically to perform
some joint purpose inside the firm rather than accessing
commercially available assets through a skein of contracts is not
done primarily to guard against opportunism and recontracting
hazards
 Instead, it Is done to ensure the maintenance of effective
coordination and alignment of assets/resources/competences
over time as circumstances change
 This adaptation is often more easily accomplished by managerial
fiat inside the firm than through the price system, an argument
perhaps first made by Barnard (1938)

Transformation/Renewal
 Transformation issues reside between two extremes:
 On one extreme, it is frictionless organizational world of
mainstream microeconomic theory, in which production
technologies can be swapped modified
 At the other extreme lies path dependence, captured by
the organizational ecology view that some kind of
organizational inertia (irreversibility) prevents most
firms from changing in response to existential strategic
threats

 in cases where a commitment is costlessly reversible,
uncertainty poses no problem for the firm (Arrow, 1973)
 With zero cost irreversibilities, there would be no need to
peer into the future because, if today’s plan proves
unprofitable, the firm can try something different tomorrow
without penalty
 With zero cost irreversibility, there would be no path
dependence, and strategic renewal would be a
straightforward affair
Irreversibilities and the impact on
renewal: Ken Arrow’s insight

Implications
 Irreversibility are not, however, simply a design or production
challenge flowing from past purchases of physical capital
 Past commitments to strategic plans also create strategic
inflexibilities. These situations are qualitatively different
(behavioral) from irreversible physical capital and should be
analyzed separately

 Organizational structures, culture, and dynamics create a
different- and probably more significant irreversibility
 Dorothy Leonard-Barton (1992) noted that the source of a
company’s strength can become a “core rigidity” that inhibits
its development
 It is often harder to repurpose an organization than to
repurpose a technology. The latter is often little more than
writing a check; the former requires organizational
reengineering
Organizational structure & culture can
amplify or ease irriversibilities

Figuring out how to manage/improve the
agility/efficiency tension between aids
renewal and strengthens dynamic
capabilities
 Agility is the capacity of an organization to efficiently and
effectively redeploy / redirect resources to value creating and
value protecting activities as internal and external
circumstances warrant
 Agility is costly to maintain and need not always be desirable
(when constructing Shinto Temples, change is undesirable)
 “The ability to calibrate the requirements for change and to
effectuate the necessary adjustments would appear to depend
on the ability to scan the environment, to evaluate markets and
competitors, and to quickly accomplish reconfiguration and
transformation ahead of competition” (Teece, Pisano, and
Shuen, 1997:521)
54

 Dynamically capable firms have more than agility and
ambidexterity
 Too often, agility is defined as the ability to do commonplace
things faster and cheaper. If that’s what one means by agility, it
is more akin to ordinary (rather than dynamic) capabilities
 When agility refers to a reduction in the time required to reach
best practices, it is simply an incantation for Six Sigma, Value
Engineering, or other efficiency initiatives
 Those may be necessary for the organization to become more
efficient; but they are only secondarily related to conferring
evolutionary fitness
 What matters most is management’s ability to redeploy physical,
financial, and human assets to new and better commercial
avenues
Dynamic capabilities emphasizes a special
kind of agility/ambidexterity

56
The Tradeoff between Efficiency and
Agility is different in Organizations with
Strong/Weak Dynamic Capabilities

The prioritization of ordinary
capabilities can weaken dynamic
capabilities & vice-versa
 As Benner and Tushman (2003) elegantly stated it as follows:
“Activities focused on measurable efficiency and variance reduction
drive out variance-increasing activities and, thus, affect an
organization's ability to innovate and adapt outside of existing
trajectories ... Core capabilities may become core rigidities” (Benner
and Tushman, 2003: 242)

Capability/efficiency choices at Pepsi
58
“I had a choice. I could have gone pedal to the metal, stripped
out costs, delivered strong profit for a few years, and then said
adios. But that wouldn’t have yielded long term success. So I
articulated a strategy to the board focusing on the portfolio we
needed to build, the muscles we needed to strengthen, the
capabilities to develop…we started to implement that strategy,
and we have achieved great shareholder value while
strengthening the company for the long term.”
Indra Nooyi and Adi Ignatius, “How Indra Nooyi Turned Design Thinking
Into Strategy: An Interview with PepsiCo's CEO,” Harvard Business Review
(September 2015).

Transformation is about redeploying
financial, physical, and human resources to
effectuate organizational change
 What’s needed is some kind of dynamic optimization, rather
than the static optimization. Lou Gerstner, IBM’s former
(turnaround) CEO put it this way:
“In anything other than a protected industry, longevity is the capacity
to change ... If you could take a snapshot of the values and processes
of most companies 50 years ago—and did the same with a surviving
company in 2014—you would say it’s a different company other than,
perhaps, its name and maybe its purpose and maybe its industry. The
leadership that really counts is the leadership that keeps a company
changing in an incremental, continuous fashion. It’s constantly
focusing on the outside, on what’s going on in the marketplace,
what’s changing there, noticing what competitors are doing.”
(Davis and Dickson, 2014: 125).

• Strategic “fit” over the long run
(evolutionary fitness)
• Sensing, seizing, shaping and
transforming
• Difficult ; inimitable
• Technical efficiency in basic
business functions
• Operational, administrative,
and governance
• Relatively easy; imitable
Ordinary
Capabilities
Dynamic
Capabilities
Doing things “right” Doing the “right” things
Dynamic Vs. Ordinary US Dynamic Capabilities
Summary Chart
Purpose
Tripartite
schema
Imitability
Purpose

VII. CAPABILITIES AND STRATEGY

Congruence (with strategy & capabilities)
is important, and general systems theory
alerted us to this 50 years ago
 Systems theory views organizations as social systems existing in
different environments with units that must be associated if the
organization is to be effective (Churchman, 1968)
 The underlying logic was later redeveloped into a pragmatic
model of organizational alignment by Nadler and Tushman
 The Nadler-Tushman framework might be lacking some critical
components. A business model, for example, defines the
architecture of a business, specifying the value proposition to the
customer and how the delivery of value is to be monetized
(Teece, 2014). It is missing from the framework
62
EVEN IF ALL INTERNAL COMPONENTS FIT WELL TOGETHER,
THE ORGANIZATION MAY FAIL IF IT DOESN’T FIT WHAT THE
MARKET REQUIRES AND ITS BUSINESS MODEL IS
MISSPECIFIED

63
“You have to be fast on your feet and
adaptive or else a strategy is useless.”
Charles de Gaulle, French general and statesman

Strategy is complementary to dynamic
capabilities
“A good strategy is a ‘specific’ and ‘coherent’ response to—and approach for
overcoming—the obstacles to progress.”
“A bad strategy is a list of blue sky goals or a fluff-and-buzzword infected ‘vision’
everybody is supposed to share.”
- Strategy Kernel (Rumelt, 2009)
Diagnosis Guiding policy Coherent action
64

While they are analytically distinct
concepts, strategy and capabilities are,
in practice, closely related
 Sensing is important to dynamic capabilities but also contains a
strong element of diagnosis, which is important to strategy
 Seizing needs to be connected to both a guiding policy and
coherent action; and transforming that is value protecting and
enhancing requires a guiding policy and coherent action.
 Put differently, the managerial orchestration that is core to
enhancing processes and exploiting positions must be guided
and informed by strategy- and vice-versa. Strategy needs to be
aligned with capabilities

Interrelationship capabilities & strategy
 Dynamic capabilities guide decisions such as
which products to make and which customers
to target.
 Strategy helps to determine the timing of
market entry and how to keep competitors at
bay

“Resources” (number & tonnage of warships) isn’t
decisive: Stalemate at the Battle of Jutland where
strategy was absent
The British Navy at the
Battle of Jutland, 1916
“There seems to be
something wrong with our
bloody ships today.”
Admiral John Jellicoe
“The real deficiency, however, was the
loss of [Vice Admiral Horatio Lord]
Nelson’s touch. It was not the bloody
ships that were principally at fault. It
was the inadequate doctrine of
command and control.”
Frank Hoffman, “What we can learn from Jackie Fisher,”
Proceedings of the Naval Institute, April 2004, p. 70.
67

Aligning agility & strategy – The Battle of Trafalgar
68

VIII. Enhancing/modifying
capabilities & closing capability gaps

Closing capability “gaps”
 Capability gaps are of at least three kinds:
 Technology gaps
 Market gaps
 Business model gaps

Recognizing capability gaps isn’t
straight forward
 The first challenge is to understand the location and
magnitude of capabilities deficiencies
 Often it is only after an organization tries to do
something (and fails) that the gap is apparent. The
early phase of a project looks okay because there are
typically few outcomes metrics to evaluate
 Later on, problem begin to crop up, the senior team
gets more and more involved, and the goal slips further
away
 Ad hoc “solutions” are attempted and failed. Only then
is there general recognition of a capability gap

There may or may not be a resource gap
behind an identified capability gap
 Resources are not capabilities
 There may be budgets and people assigned to a project
(resources) but, if employee capabilities are not strong,
performance failure is likely
 Building capabilities is hard; the silver lining is that, once built,
they are then difficult for others to imitate
 Put differently, the absence of a market for capabilities means
that benefits can flow from entrepreneurial and managerial
activity that builds and hones value-creating capabilities

Organizational instincts tend to
compel the exaggeration of current
capabilities
 The search for capability gaps begins by examining the match
between a proposed business model and the firm’s existing
capabilities
 An analysis of existing capabilities needs an objective point of
view that is detailed and realistic

What is critical are abilities to:
 Recognize what capabilities are needed
 Develop them quickly, efficiently and effectively. This itself is
a dynamic capability (Feiler and Teece, 2014)

Market Distance
Business Model Distance
Technological Distance
Target state relative to current “O”
O
Current state
Capability gaps & the transformation challenge

IX. THE DYNAMIC CAPABILITIES
FRAMEWORK: UNFINISHED BUSINESS

A new (capability) theory of the firm
animated by deep uncertainty,
innovation, and building/deploying
non-priced assets can be imagined?
 The dynamic capabilities framework incorporates an
entrepreneurial theory of the firm that starts from a more
primitive initial state than the one assumed in most economic
models
 In the Coase-Williamson framework, for example, many
markets, technologies, and prices exist already (Boudreaux and
Holcombe, 1989)
 In reality, entrepreneurs must first cut through uncertainty and
create each market before there are preferences and prices that
can lead to market activity (Frank Knight,1921)

Many untidy Issues in Dynamic Capabilities
 Seizing is about galvanizing the enterprise and making the
investments (and implementing the business models) to
embrace new opportunities and guard against threats
 The impact of significant investments behind this modality
(seizing) can of course also be transformational and lead to
what is tantamount to renewal
 So how does one distinguish between seizing and renewal?

 “Seizing” could be anchored to early stage business
evaluation while transformation/renewal could be late stage
(mature firm) changes.
 “Seizing” could be scaling i.e. investing to expand existing
businesses while transformation and renewal might relate to a
change in strategy and the launch of new products. The
difficulty emerges because both seizing and transformation
first require sensing.
 “Seizing” implicitly assumes that transformation isn’t first
required. This means (a) the organization is new and/or
seizing doesn’t require a change in business model (b) the
legacy structure of the organization isn’t a barrier to success.
79
Sensing
Seizing
Shifting/
Transforming

Dynamic capabilities as general
management systems theory “light”
 “One of many objectives of General Systems Theory is to
develop a framework of general theory to enable one specialist
to catch relevant communications from others” (Boulding, 1956)
 “There is not much doubt as to the demand for it. It is a little
more embarrassing to inquire into the supply”, (Boulding, 1956)
Dynamic capabilities is an effort to build the necessary
interdisciplinary framework

X. DYNAMIC CAPABILITIES AND
RELATED PARADIGMS
81

Related Paradigms
1. General System Theory
2. Profiting from Innovation
3. Open Innovation
4. Lean Startup
5. Strategy Palette
6. Knowledge Creation (SECI) Paradigm
7. Remix
8. OODA Loops
9. Disruption
10. Evolutionary Economics
11. Transaction Cost Economics

General Systems Theory
Aristotle C. West Churchman Kenneth Boulding

 Knowledge is derived from the understanding of the whole and
not that of the single parts (Aristotle's Holism)
 The relationships between the parts themselves and the events
they produce through their interaction are the essence of system
theory
 General systems theory found its way from biology (Ludwig von
Bertalanffy) into management and economics via Ross Ashby,
Chester Bartnard, Kenneth Boulding, & others and was popular in
management in the 1960’s & 1970’s!
 Dynamic Capabilities is a workable systems theory
Copyright Teece 84

Herbert Simon described the
challenge for a systems approach:
“In both science and engineering, the study of "systems" is an
increasingly popular activity. Its popularity is more a response to
a pressing need for synthesizing and analyzing complexity than
it is to any large development of a body of knowledge and
technique for dealing with complexity. If this popularity is to
be more than a fad, necessity will have to be the mother of
invention and provide substance to go with the name”
Source: "The Architecture of Complexity," in Joseph A. Litterer, Organizations: Systems,
Control and Adaptation, Vol. 2 (New York: John Wiley, 1969)
Copyright Teece 85

The Multidisciplinary requirements
of systems theory are considerable
 Academics are hampered because each of the academic disciplines
has taken a narrow "partial systems view" many scholars and
practitioners find comfort in the relative certainty which this creates.
 Academic’s & Practitioners alike do an admirable job of delineating
and discussing accounting, marketing, operations, manufacturing, &
strategy as separate activities. However, they are often unable to
discuss them as integrated and interrelated activities.
 Even though manager’s sometimes preach a general systems
approach, they often practice subsystems thinking.
Copyright Teece 86

Congruence theory developed out of
 Congruence is the idea that certain things work best with certain other
things, and that failure is all but guaranteed when elements of a system
are mismatched. Russell Ackoff puts it this way:
“Suppose you could build a dream car that included the styling of a Jaguar, the
power plant of a Porsche, the suspension of a BMW, and the interior of a Rolls
Royce. Put them together and what have you got? Nothing. They weren’t
designed to go together. They don’t fit. The same is true of organizations.”
(Mercer Delta Consulting, 2004:7)
 Systems theory views organizations as social systems existing in different
environments with units that myst be associated if the organization is to
be effective (Churchman, 1968)
 The underlying logic was later redeveloped into a pragmatic model of
organizational alignment by Nadler and Tushman

 Brings Knightian uncertainty, Marshallian evolution, Penrosean
resources, Schumpeterian creative destruction, Keynesian
“animal spirits,” and Coase-Williamsonian transaction costs
and Boulding’s (1956) General Systems Theory together
 It can potentially explain not only why firms exist, but also
their scope and potential for growth and sustained
profitability in competitive markets riddled with deep
uncertainty
The dynamic capabilities framework
as General Systems Theory Redux?

The dynamic capabilities framework is
hard to master given that our education
system favors deep specialization
 As with general systems theory, no simple cookbook or 5 Forces
distillation
 Competing approaches/models ignore innovation, don’t
recognize interdependencies, eschew entrepreneurship
 Dynamic capabilities is more difficult to comprehend and apply
but can be the foundation to a more thorough understanding of
complex reality
 Good (silicon valley type) managers have an intuitive dynamic
capabilities/systems view of the world. By making elements
and inter-relationships more explicit, dynamic capabilities can
galvanize managers and management to action
Copyright Teece 89

Implications for Management
Managers following dynamic capabilities precepts:
 See the enterprise and the extended environment (market and
technological and regulatory developments) as a whole
 Avoid analyzing problems in isolation, follow integrated approaches,
and know how and when to prioritize ordinary and dynamic
capabilities
 Understand internal and external ramifications
 Are entrepreneurial and good communicators/networkers inside
and outside the enterprise.
 Understand functional interdependencies of units/activities
inside and outside the enterprise
Copyright Teece 90

The Dynamic Capabilities Framework
is Integrative and draws on numerous
concepts, tools, and fields
91
EXAMPLES:
Concepts and Tools used Fields Embraced
• Profiting from Innovation • Innovation Management
• Business Model Design • Knowledge Management
• Decision analysis • Leadership & change management
• Economic analysis • Marketing
• Entrepreneurship • Operations management
• Finance • Organizational Behavior
• Complexity Theory

UNDERSTANDING DYNAMIC CAPABILITIES AS
A SYSTEM: VERSION ONE
Source: Teece “Explicating Dynamic Capabilities,
Strategic Management Journal, 2007

93
UNDERSTANDING DYNAMIC
CAPABILITIES AS A FRAMEWORK
SYSTEM: VERSION 2

Casual Connections in the Dynamic
Capabilities System/Framework
Copyright Teece 94
Source: Teece, AMR 2014

Profiting from Innovative (PFI)
95
• Provides algorithms for “seizing” and predicts the
division of profits
• Core variables are: (i) appropriability regime; (2)
timing; (3) ownership of complementary assets
D. Teece, "Profiting from Technological Innovation," Research Policy 15:6 (December 1986), 285–305.
(Selected by the editors as one of the best papers published by Research Policy over the period 1971–1991.
Profiting from Innovation (PFI)

96
Start
Here
Innovation requires
access to
complementary assets
for commercial success
Commercialize
Immediately
Complementary
assets specialized
Appropriability regime
weak
Specialized asset critical
Cash position OK
Imitators/Competitors
better positioned
Contract for Access
Contract for access
Contract for access
Contract for access
Contract for access
Integrate
Yes
Yes
Yes
Yes
Yes
No
No
No
No
No
No
Yes
Business Model Implications:

Profiting from innovation
 PFI is a product-level, not a firm-level construct
 PFI didn’t focus much on the entrepreneurial side
(complementary asset orchestration) because for simplicity
it was looking at a static issue: How to commercialize an
(assumed) winning technology and profit from doing so
 Despite the static framework, the essence of the thesis is
nevertheless intact … owning/controlling the bottleneck
(assets) is still job #1 and the gateway to one shot riches
 Effectuating asset accumulation and continuous asset
orchestration requires a wider aperture lens. When wide
open, dynamic capabilities come into focus
97

Bridging from PFI to Dynamic
Capabilities
 For simplicity, PFI is static and assumes that a commercially
viable invention is at hand: its focus is on value capture. (It
assumes value creation is accomplished)
 PFI provides little insight into the mechanisms which
complementary assets/technologies are developed &
assembled/orchestrated
 Dynamic capabilities puts resources/PFI approaches “on
wheels” & helps us understand how firms figure out what
new products/processes/projects to bet on in a world of
deep uncertainty where innovation requires harnessing
complementary assets
 Adner’s work makes an important contribution to
understanding how the complements need to be
orchestrated
98

Types of Complementarity: Summary
Type Representative Authors Description
Production Hicks (1970)
A decrease in price of X leads to an increase in the
quantity of Y
Consumption Edgeworth (1897/1925)
An increase in the quantity demanded of X leads to
increased demand for Y
Asset Price Hirshleifer (1971)
Financial arbitrage opportunities are created by
foreknowledge of the probable impact of an
innovation.
Input Oligopoly Cournot (1838/1960)
Inputs X and Y will be sold for less if the companies
can collude to maximize profits.
Technological
Teece (1986, 1988b,
2006)
Unlocking the full value of an innovation requires
additional innovation in one or more horizontal,
lateral, or vertical complements; ownership of
complements aids appropriability.
Innovational
Bresnahan & Trajtenberg
(1995)
Improvements in a GPT increases the productivity of
goods in downstream applications.

Bringing the plethora of complements into
focus
 Adner’s “Wider Lens” is a
halfway house between PFI &
Dynamic Capabilities. It is most
insightful & outlines the
importance of “lining up all the
ducks” to achieve commercial
success
100
Ron Adner, Dartmouth

Adner correctly points out that the
innovators success at PFI likely depend on
the combined efforts of multiple partners
Adner’s Examples:
 Better place LLC which is working on batteries for hybrids
 Apple’s iPod & iPhone*
 Self-healing tires
Teece Examples:
 Lockheed L1011 & Rolls Royce delay in developing the RB211
engine
 Boeing Dreamliner
Chesbrough & Teece Example:
 Cell phone handset and battery producers need some in-
house R&D in order to pace technology development (HBR,
1996)
101
*See: Teece, “Dynamic Capabilities: A Guide for Managers,” Ivey Business Journal (March/April 2011).

Adner’s “The Wide Lens” value blueprint
methodology
102
Stresses:
• the importance not only of alignment with customers but
also with investment partners to minimize co-innovation risk
• The role of ecosystem leader (the ecosystem “captain”)
• Helps one identify gaps in complementary
assets/capabilities
• Adner’s (implicit) focus is evolutionary fitness (dynamic
capabilities)
A useful methodology to help clarify the structure
of required collaboration, i.e. who hands off what
to who & when?

Adner’s modified PFI thesis:
The PFI (Teece) proposition:
The major prize might also go to the party that puts down
the first piece. It depends on whether or not the “piece” is
the bottleneck. The scarcity of the underlying resource has
much to do with the answer. (e.g. is it is protected by
intellectual property?)
103
*Adner interview in Brian Leavy’s, “Ron Adner: managing the interdependencies and risks of an
innovation ecosystem”, Strategy and Leadership, (2012).
Adner proposition:
“The major prize was destined to go, not to the party that
puts down the first piece of the puzzle, but the one that
puts down the final piece.”*

Ram Mudambi/Stan Shieh “smile analysis”
is a valuable extension of PFI?
 Upstream: Design, basic and applied research
 Middle: Manufacturing, standardized service delivery
 Downstream: Marketing, advertising, & other repetitive
processes
Mudambi Thesis: Successful creating and capturing value
depends both on control and locational “linkages” (per
Albert Hirschman)
104
Value chain levels:

Smile Curve indirectly leverages
PFI/VRIN/Dynamic Capabilities
theories/frameworks
105
Source: Mudambi, 2008

Smile Curve Dynamics
1. Ends of the smile curve reflect difficult to replicate assets
2. Improving process (ordinary) technology depresses the
middle
3. Ends are pulled up by increased personalization &
customization in design & delivery (VRIN attributes)
4. Firms at the bottom of the smile have strong incentives to
integrate out & up & do so by learning
5. Moving to the corners of the smile requires innovation &
Dynamic Capabilities (and innovation)
106

Key “smile curve” takeaways
107
Intangible assets are core to value capture
Coordination across organizational boundaries &
orchestration of the entire network is particularly
important to the success of modulization
Disaggregating the value chain requires standards
Dynamic Capabilities are relevant

PFI & Dynamic Capabilities
 PFI is about capturing value
 Creating & capturing value from innovation & sustaining innovation long-term
is the essence of Dynamic Capabilities provides the wider aperture lens that is
needed
108
Value
(Sensing)
Capturing
Creating
Value
(Seizing)
PROFITS
Ordinary
Capabilities
Transforming
Seizing an
opportunity
and “capturing
value” (PFI)
Sensing
opportunities &
creating value
(possibly
through R&D)
Dynamic Capabilities
Strategy
Resources
PFI Domain

Open Innovation
“The use of purposive inflows and outflows of
knowledge to accelerate internal innovation,
and expand the markets for external use of
innovation, respectively.”
Henry Chesbrough et al,
Open Innovation: Researching a New Paradigm, Oxford University Press, 2006
109
Henry Chesbrough

Features of Open Innovation
110
• Recognizes that not all ideas/new products can be developed
internally.
• Relentlessly focused on how to augment internal efforts through
accessing external ideas and resources and combining them with
critical ideas and resources
Lineage
• Companies have always relied (to some degree) on external
sourcing of ideas and innovations
• However, during the heyday of (i) large corporate R&D labs
(1920’s-80’s) and (ii) US technological dominance (1940-90)
habits of thinking because quite parochial
• Many companies remain caught in the “not invented here”
trap

Some elements of open innovation have been
around for decades
1. Knowledge Dispersion: Greater geographic and
organizational dispersion in the sources of new knowledge
2. Speed: Need to achieve “integration” and new product
launch rapidly because of stronger (global) competition
3. Intellectual property: Stronger IP right expand choices with
respect to internal development or licensing
4. Standards: Publication/acceptance of standards facilitates
crowd sourcing
STRONGER GLOBAL COMPETITION HAS ENHANCED THE
IMPORTANCE OF OPEN INNOVATION
111

Open Innovation Enhances Dynamic
Capabilities
112
The open innovation framework can enhance
dynamic capabilities (with respect to all
three classes of micro-foundations) through
explicit recognition that sensing and seizing
can be extended to external stakeholders and
also to members of crowds

Lean Startup
An approach to entrepreneurship and new enterprise
development
• Emphasis on learning and pivots
• Deemphasizes planning
113
Eric Ries
E.Ries, “The Lean Startup”, Crown Business; First Edition edition (September 13,
2011)

Learning Under Deep Uncertainty is Key
“ I’ve come to believe that learning is the essential unit of
progress for startups. The effort that is not absolutely
necessary for learning what customers want can be
eliminated. I call this validated learning because it is always
demonstrated by positive improvements in the startup’s core
metrics”
Eric Ries, The Lean Startup, 2011, p.49
114

“Tuning” and “Pivots” … two lean startup
concepts that mesh with dynamic
capabilities
 Ordinary capabilities involve “tuning the engine”… a process
of optimization
 Circumstances often require a change in strategy or in
business models. This is called “pivot” and requires
agility…which is relatively easy for a startup
115

What Entrepreneurial Managers Do and Don’t
Do Consistent with Dynamic Capabilities
 They rarely become infatuated with setting MR=MC…though
every so often technical and financial support personnel may
perform such calculations.
 Rather, in real life… a lot is happening
simultaneously…acquiring new customers and serving existing
ones, raising capital, building capabilities, trying to improve
the product, improving operations, deciding if and when to
pivot
Eric Ries, The Lean Startup, 2011, p.24
116

Issues with Lean Startup
 Focus is on startup…only one aspect of what’s required for
established companies to have dynamic capabilities
 Not explicitly grounded in theoretical framework…but deep
uncertainty is implicit
 Mechanisms for sensing and seizing not well specified
117

Reeves (BCG):
Strategy Needs Strategy
• Offer “strategy palette” to combine different approaches
• Defines business environment according to predictability, malleability and
harshness
• Strategies should be selected according to environment e.g. “classical” when
there is low unpredictability and low malleability; renewal when there is
harshness (Classical approaches include BCG growth matrix and Porter’s 5 forces)
• Adaptive strategies are suitable when prediction is hard and advantage is short
lived
• Visionary strategies work when managers can reliably create (shape) or recreate
(reshape) an environment all by themselves
118
M, Reeves, “Your Strategy Needs a Strategy: How to Choose and Execute the Right Approach”, Harvard Business
Review Press (May 19, 2015)

Different approaches to strategy
required across the business life cycle
119
Adaptive Shaping
Visionary
Classical
Unpredictability
Malleability
M, Reeves, “Your Strategy Needs a Strategy: How to Choose and Execute the Right Approach”, Harvard Business
Review Press (May 19, 2015)

Elements in Common with Dynamic
Capabilities
 The classical approach to strategy is not relevant unless there is no
imminent risk of disruption
 The right strategy depends on the circumstances facing the firm
 Classical disciplines of focus, efficiency, planning, and
accountability work where the business is highly “planable”
 Growth per se is not a strategy…it needs to be focused not
indiscriminate
 Firms need to understand where and how profit is generated…
 Firms can (sometimes) win, even if scale disadvantaged, by building
and displaying superior capabilities that are hard to replicate
 Doing things right can be a comforting substitute for insight
generation
120

Elements in Common with Dynamic
Capabilities, Con’t.
 Ambidexterity is valuable
 With high uncertainty, firms should engage other
stakeholders to create a shared vision and orchestrate new
combinations
121

What’s Missing?
 Not a coherent framework
 Ideas and concepts are somewhat jumbled…unclear
implications
 Not tied to fundamental concepts, so hard to understand,
elaborate and improve
122

Knowledge Creation:
(SECI) Paradigm
123
• The organization creates knowledge through action and interaction
• The organization “interacts with its environment, and reshapes the
environment and even itself through the process of knowledge creation”
(p6)
• “The most important aspect… is the dynamic capability to create new
knowledge and of existing firm-specific capabilities.” (p6)

SECI Processes
124
Socialization: Process of tacit knowledge is acquired through shared
experiences
Externalization: Process by which tacit knowledge becomes explicit
Combination: Process of converting explicit knowledge into something
more complex and systematic
Internalization: Process of embodying explicit knowledge into tacit
F2F (“Ba”) Leads to shared experiences which undergird Nonaka’s
knowledge spiral
“The knowledge creating process involves dynamic interactions
between organizational members… and the environment”

125
• Based on abduction type
logic, SECI requires
additional effort to
demonstrate how knowledge
creation can be married to
open innovation and dynamic
capabilities
Further research: open innovation &
Knowledge co-creation

126
Observe: Taking note of features of the environment (e.g. detecting enemy
aircraft)
Orient: Pointing ones aircraft towards the adversary
Decide: Decide what to do next
Act: Implementing what has been decided
(firing the missile)
Boyd’s Approach Favors Agility Over Raw Power,
Dynamic Capabilities Advances a Related and More Central Learning &
Decision Making Process
A Generalized Model of Learning & Intelligent
Decision-Making: OODA Loops
Orient
Decide
Act
Observe
Colonel John Boyd

Disruption
• A process whereby a smaller company with few resources successfully
challenges an incumbent
• Incumbents are vulnerable when they focus on improving their products
and services for their most demanding customers (causes them to be
“blindsided” by new entrants)
• New entrants grow traction at the lower end, then more upmarket
• When mainstream customers start adopting the entrants offerings in
volumes, disruption has occurred
127
C. Christensen, “The Innovator's Dilemma: The Revolutionary Book That Will Change the Way You Do Business”,
HarperBusiness; Reprint edition (October 4, 2011)
Clay Christensen

128
• Disruptive innovations originate in (a) low end or (b) new
market foothold
• Unless a new entrants is on a disruptive trajectory, it can be
ignored
• Under Christensen’s definitions, Netflix is a disruptor; Neither
Uber nor Tesla are
 Implications
 Because disruption can take time incumbents frequently
overlook competition
 Disruptions often build different business models which may
lower their competitive profile
 Learning ( by the new entrant) and strategic blind spots
(framing errors) by the incumbent are implicit in the
paradigm

 Firms seen as information processing and problem solving
entities which interpret signals coming in from the
environment (Cyert & March, March & Simon Lineage)
 Adaptation is the key behavioral algorithm
 Normaltive/Prescription implications
a) Firms adapt
b) Change is incremental (local)
c) Local mutation is possible
 Formalized through Kauffman and Levin NK models:
 K= Complexity of landscape, N= Number of components
of the system; hills & valleys represent profit
129
EVOLUTIONARY
ECONOMICS
Richard Nelson Sidney Winter

Evolutionary/Behavioral Economics (& NK
Models)
 Essence of organization is a problem solving grounded on
imperfect & boundedly rational processes of learning and
search
 Strategic substance of capabilities involves patterns of
activity requiring investment in R&D (Intel)
 Ad Hoc problem solving juxtaposed against dynamic
capabilities (Winter 2003)
 NK models used to formalize a capabilities approach… but
may not be consistent with the dynamic capabilities
framework
130

Evolutionary economics applied to
management
 In evolutionary economics, “the concept of routines and
capabilities were put forward as components for a
description theory of organizational behavior, not a source of
advice for businessmen.”*
 Deliberate acquisition of (potentially) valuable skills is part
of an intentional action by managers that can be
advantageous*
 Success is a consequence of effort and luck joined by
alertness and flexibility**
 According to Levinthal’s models, organizations trapped in
local optima can reach, at low probability, global optima
though radical mutations
 No strong managerial implications
*S.G. Winter, “Problems at the Foundation? Comments on Feline Foss, Journal of Institutional Economics, 7(2) p.
257-277, (2011).
**Denrell, Fang, and Winter, Strategic Management Journal (2003).
131

132
Primary Intellectual Lineage
Evolutionary Economics Dynamic Capabilities
March
Simon
Cyert
Alchian
Schumpeter
Kirzner
Arthur
Chandler
Schumpeter Entrepreneurship &
adaptation at the core
Adaptation at the core Penrose
Dynamic Capabilities drives entrepreneurial action, not
just to adapt to but to shape the environment

What does evolutionary economics and
dynamic capabilities have in common?
 Production functions are inadequate and misleading
abstractions of the firm
 Organizations/firms display persistent heterogeneity in their
performance
 Adaptation is at least one attribute of firms with Dynamic
Capabilities. Evolutionary/ecological perspectives see
change as very hard and path dependency as mostly
inexorable
133

Transaction Costs Economic (TCE)
 TCE Stresses opportunism and recontracting hazards
 Rather than stressing opportunism (although opportunism
surely exists and must be guarded against), the emphasis in
dynamic capabilities is on building (through investment and
through learning) unique specialized assets and on keeping
the enterprise aligned with its business environment
 The associated activities include research and development,
business architecture transformation, asset selection, and
asset orchestration
OPPORTUNITY V. OPPORTUNISM: The emphasis in
dynamic capabilities is on creating valuable and
distinctive assets that transaction cost economics
assumes are somehow already available
Oliver Williamson

 TCE is static and can be categorized as
highlighting ordinary capabilities
 It assumes the existence of capabilities and
focuses on the right governance structures
 It outlines preferred governance
arrangements according to asset specificity
requirements
 The “fundamental transformation” is,
however, a dynamic element

Dynamic Capabilities, Related Paradigms, and Competitive Advantage in the Innovation Economy

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