Presentation for the Babbage Forum at Cambridge University

1. DYNAMIC CAPABILITIES:
WHAT ARE THEY
AND HOW THEY CAN
BE APPLIED
David J. Teece
2018 Babbage Forum,
Cambridge University
September 26, 2018
1

2. “The proximate cause [of differences in
the wealth of nations] lies, for the most
part, in the capabilities of firms.” (italics
added)
- Prof. John Sutton, London School of
Economics
2

3. WHY CAPABILITIES?
• The (neoclassical) economic theory of the firm is silent
on capabilities, just as it is silent on the role of the
manager and the entrepreneur in the economy.
• Without a theory of capabilities, how can we have a
theory of the firm?
• How can governments design policies to help develop
enterprise capabilities without an understanding of what
they are, where they came from, and how they can be
strengthened?
3

4. GROWING DISPERSION IN TOP AND
BOTTOM PROFIT MARGINS OF FIRMS
4
0
0.05
0.1
0.15
0.2
0.25
1965
1971
1977
1983
1989
1995
2001
2007
2013
75th
Percentile
25th
Percentile
Source: Compustat
Notes:
• 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

5. THE EVOLUTION OF STRATEGIC MANAGEMENT &
“RESEARCH BASED” THINKING
5 Forces*
• Industry
attractiveness
is the central
focus
• External forces
dominate
• Fate = static,
purely
competitive
markets
(low profit)
RBV**
• VRIN assets
drive value
creation
• Barriers to
competitio
n
determine
longevity
• All 4 VRIN traits
necessary to
sustain
advantage
Dynamic
Capabilities***
• Markets are dynamic
and competition is
often disruptive
• Asset orchestration
& strategy drive
advantage
• Reshaping
ecosystems & biz
models is critical
1980
s
1990
s
2000
+
The Dynamic Capability model is only the third substantive framework for
maintaining competitive advantage to emerge in the last 35 years
5
Deep
Uncertainty
Risk
*Michael Porter **Resource-based view of Jay Barney ***Originated with Teece, Pisano &
Shuen, 1997

6. ORDINARY CAPABILITIES LEAVES
MANAGEMENT
AND EMPLOYEES RUNNING FAST TO
STAND STILL (“BURNOUT”)
6
Lewis Carroll, “Through the Looking
Glass”

7. STRONG “ORDINARY” (OR NORMAL)
CAPABILITIES: ENABLES RESOURCES TO BE
USED EFFICIENTLY, BUT NOT NECESSARILY IN
THE RIGHT PLACES
• Manufacturing, operations, administration and governance are core
ordinary capabilities
• Good routines/standard operating procedures and best practice
manufacturing underlie strong ordinary capabilities
• Good ordinary capabilities reflect strong technical efficiency
• Competitive advantage based on good manufacturing can diffuse
rivals because:
• Much manufacturing is now in the public domain
• Engineering schools teach best practices
• Management consultants help implement best practices
• Admittedly, not everyone gets the simple stuff right – but
enough do that it erodes competitive advantage.
7

8. DYNAMIC CAPABILITIES
DEFINED
• The ability of an organization and its
management to integrate, build, and reconfigure
internal and external competencies to address
rapidly changing environments.1
• Dynamic capabilities are about doing the right
things; ordinary capabilities are about doing
things right.
8
1Teece, Pisano and Shuen, Strategic Management Journal, 1997

9. 9
KEYNE’S “ANIMAL SPIRITS” FORESHADOWED
“DYNAMIC CAPABILITIES”
• The Keynesian concept of “animal spirits” is
very consistent with the bold decisions
required by dynamic capabilities.
• Weaker firms and management teams are
indecisive, and usually wait too long for
uncertainty to be resolved.
• Stronger firms are decisive: they develop real
options, which they exercise judiciously but
quickly.
• Strong dynamics capabilities are the catspaw
of firm level competitive advantage.

10. DYNAMIC CAPABILITIES CAN BE
THOUGHT OF AS FALLING IN THREE
CATEGORIES1:
10
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
1See David J. Teece, “Explicating Dynamic Capabilities: The Nature and
Microfoundations of (Sustainable) Enterprise Performance,” Strategic Management
Journal, December 2007

11. SENSING AND SENSE-MAKING –
PROCESS OVERVIEW
Sensing processes incorporates four main steps – sensing, sense-making, scenario
narratives,
hypotheses development – that lead either to action (“seizing” and “shifting” activities),
further reflection and interpretation (sense-making activities), or further exploration
(sensing)
Sensing
Sense-
Making
Scenario
Narratives
Hypotheses
Seizing
Activities1
Shifting
Activities1
Action Outcomes
Further
Exploration
Further
Interpretation
Further
Refinement
Reflection Outcomes
Note 1: Source – Developing Organizational Resilience: A Dynamic Model to Sustain Competitive Advantage, Teece, Raspin, and
Cox. 2018
11

12. SENSING IS THE ABILITY TO SEE
AROUND CORNERS
12
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.”
Jack Welsh
Kenneth Boulding
The future is bound to surprise us,
but we
don’t have to be dumbfounded.
– Kenneth Boulding

13. ASSET ORCHESTRATION IS CENTRAL 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)
13

14. TRANSFORMATION
 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 and cultural
change.
14

15. THE DIFFICULTY OF
TRANSFORMATION DEPENDS
ON THE “DISTANCE” AN
ENTERPRISE MUST TRAVEL
15

16. DYNAMIC VS. ORDINARY DYNAMIC
CAPABILITIES
16
• Strategic “fit” over the
long run (evolutionary
fitness)
• Sensing, seizing,
shaping and
transforming
• Difficult; inimitable
Ordinary
Capabilities
Dynamic
Capabilities
Doing things “right” Doing the “right” things
Tripartite
schemes
Imitabilit
y
• Technical efficiency
in basic business
functions
• Operational,
administrative, and
governance
• Relatively easy;
imitable
Purpose

17. DEEP UNCERTAINTY
REQUIRES STRONG DYNAMIC
CAPABILITIES
17

18. THE PRIORITIZATION OF ORDINARY
CAPABILITIES CAN WEAKEN DYNAMIC
CAPABILITIES, & VICE-VERSA
Benner and Tushman (2003) stated the tradeoff/risk
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)
18

19. DYNAMIC CAPABILITIES ARE ABOUT A
SPECIAL KIND
OF AGILITY
•Dynamically capable firms are agile and entrepreneurial.
• Too often, though, agility is defined as the ability to do
commonplace things faster and cheaper.
•When agility is used to refer 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 efficiency, but they are only
secondarily related to evolutionary fitness. What’s needed is an
entrepreneurial approach.
19
The agility that matters is associated with
management’s ability to redeploy physical,
financial and human assets into new and better
commercial avenues.

20. AGILITY/EFFICIENCY CHOICES AT
PEPSI
“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).
20

21. CAPABILITIES AND TOOLS REQUIRED
FOR STABLE & UNCERTAIN
ENVIRONMENTS ARE DIFFERENT
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
Traditional Tools/Approaches
Known
Certainty Risk
Unknown Unknowable
Uncertainty Ambiguity Chaos
Influence Diagrams
Scenario Planning
Peripheral Vision
Total Risk
Management
Systems Thinking
Idealized Design
Legitimation Theory
Honing Institution
Complexity Theory
Newer Tools/Approaches for
Sensing & Sense-Making
Domain of DYNAMIC
CAPABILITIES
Domain of ORDINARY
CAPABILITIES
21

22. STRATEGY MUST OF COURSE BE MARRIED TO
CAPABILITIES: THE BATTLE OF JUTLAND
22
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.

23. ALIGNING AGILITY & STRATEGY – THE BATTLE OF
TRAFALGAR
23

24. STRATEGIC ANALYSIS HELPS US
DETERMINE WHEN
MANUFACTURING CAPABILITIES
MATTER1
1. Where is the bottleneck in the go-to-market value
chain? Is it manufacturing?
2. What is the business model to let the innovator
control the bottleneck?
3. Bottlenecks can be proprietary standards, intellectual
property, and/or complementary assets such as
manufacturing.
4. Outsourcing is okay, but only when manufacturing
isn’t the bottleneck now and is unlikely to be in the
future.
24
1See David J. Teece, “Reflections on ‘Profiting from Innovation,’” Research Policy 35:8
(December 2006), 1131–1146.

25. MANUFACTURING &
VALUE CAPTURE
STRATEGIES
Business model
choice (licensing
vs. integrated
manufacturing)
to determine
value capture
strategy
COPYRIGHT TEECE 2018 25
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
Imitations/Competit
ors Better
Positioned
Manufacturing
(Capability)
Matters for
Commercial
Success
Contract for
Access
Contract for
Access
Contract for
Access
Contract for
Access
Contract for
Access
Yes No
No
No
No
No
Yes
Yes
Yes
Yes
Yes
No
INTEGRATE

26. “In order to tackle the grand challenges of the 21st century,
innovation policy needs to shift from the existing support-
and-measure approach (find market failure; fix it with a
support instrument; measure the impact) to innovation
policy to lead-and-learn approach (create and shape
markets with variety of policy instruments with open-ended
impact horizons, and learn through wider social
engagement and coordination)…We argue that 21st-century
missions require following set of dynamic capabilities in the
public sector …”1
26
1”Mission-oriented innovation policy and dynamic capabilities in the public
sector,”
R. Kattel & M. Mazzucato, Working Paper IIPP WP 2018-05, (forthcoming,
Industrial and Corporate Change)
GOVERNMENTS NEED
DYNAMIC CAPABILITIES TOO

27. CONCLUDING PROPOSITION
Ordinary capabilities (including manufacturing) are
not usually enough to yield sustained competitive
advantage.
Dynamic capabilities coupled with a validated strategy
enable an organization to change in a manner that
supports evolutionary fitness and sustainable
advantage.
27