Dynamic Capabilities Defined

As discussed in Chapter 1, dynamic capabilities refer to the par- ticular (nonimitability) capacity business enterprises possess to shape, reshape, configure, and reconfigure assets so as to respond to changing technologies and markets and escape the zero-profit condition. Dynamic capabilities relate to the enterprise’s ability to sense, seize, and adapt in order to generate and exploit internal and external enterprise-specific competences, and to address the enter- prise’s changing environment (Teece and Pisano, 1994; Teece et al., 1997). As Collis (1994) and Winter (2003) note, one element of dynamic capabilities is that they govern the rate of change of ordi- nary capabilities. If an enterprise possesses resources/competences but lacks dynamic capabilities, it has a chance to make a com- petitive return for a short period, but superior returns cannot be sustained. It may earn Ricardian (quasi-)rents, but such quasi- rents will be competed away, often rather quickly. It cannot earn Schumpeterian rents because it hasn’t built the capacity to be continually innovative. Nor is it likely to be able to earn monopoly (Porterian) rents since these require exclusive behavior or strategic manipulation (Teece, 1984).

An illustration of some of the issues involved in the dynamic capability framework is found in the story of the British pop group, the Spice Girls. The group made pop history in the late 1990s with their successes (being the first female group to win nine number 1 hit singles—only Elvis, Cliff Richard, Madonna, and the Beatles ever had more). The band was the result of two entrepreneurial and innovative management gurus (Bob and Chris Herbert) who in 1994 handpicked the five members to sing in a team (at first called “Touch”, the band name (and the manager) was changed in 1996). After a few years of success, the band broke up and the individual band members tried to pursue solo careers. However, none of them was able to replicate the success of the band as a team (or organization), and pop-industry experts commented that only if the band got together again would they be able to return to the success of previous years. In other words, it was the dynamic orchestration of individual skills and knowledge in the organization of the band that created the success. Once apart, their individual capabilities were no longer productive. The solo careers of several of the Spice Girls ended abruptly.

The term dynamic capabilities came into the literature with Teece, Pisano, and Shuen (1990a, 1990b). At that time clear link- ages to the resource-based approach were noted. It was put this way:

if control over scarce resources is the source of economic profits, then it fol- lows that such issues as skill acquisition and learning become fundamental strategic issues. It is in this second dimension, encompassing skill acquisi- tion, learning, and capability accumulation that we believe lies the greatest potential for the resource-based perspective to contribute to strategy. We will refer to this as the “dynamic capabilities approach”, recognizing of course that it is part of the overall resource-based perspective. (p. 9)

The treatment has subsequently broadened.

In order to position important themes in the dynamic capability framework, we outline below relevant theories that have been important inputs to the development of the dynamic capabilities framework. Our purpose is to show the behavioral foundations of dynamic capabilities, and linkages (and tensions) with evolution- ary theorizing in economics.

1. Relationship to the Behavioral Theory of the Firm

Like most scholarship in economics and organizations, the behav- ioral theory of the firm wasn’t intended to inform the field of strategic management. In fact, while strategic planning was a field of practice, the field of strategic management as we know it today didn’t exist until the 1970s or thereabouts (Rumelt et al., 1994, chapter 1).

The behavioral theory of the firm was built around a political conception of organizational goals, a bounded rationality concep- tion of expectations, an adaptive conception of rules and aspira- tions, and a set of ideas about how the interactions among these factors affect decisions in a firm (Cyert and March, 1963). Whereas goals in economic theory are pictured as given alternatives, each with a set of consequences attached, goals within behavioral the- ory are pictured as reflecting the demands of political coalitions inside organizations, changing as the composition of that coalition changes. Thus, the theory treats the demands of shareholders, managers, workers, customers, suppliers, and creditors as compo- nents of the operational goals of a firm. At the same time, not all goals are salient at all times. Rather, specific goals are evoked by the presence of coalition members in the decision neighborhood, by the divisional organization of the firm, and by the recognition of particular problems. Aspirations with respect to each dimen- sion of the goals were pictured as changing in response to the experience of the organization and its components as well as the experience of others to whom they compare themselves. Thus, it is the dynamic nature of aspirations which enables the generation of new decision alternatives. Therefore, the firm must engage in active search and imagination to create sustainable strategic oppor- tunities (Winter, 2000). In the behavioral theory of the firm, agents have only limited rationality, meaning that behavior in organiza- tions is intendedly rational; neither emotive nor aimless (March and Simon, 1958). Firms are seen as heterogeneous, boundedly rational entities that have to search for relevant information. Since information is costly, it is generated by search activity. The intensity of search depends on the performance of the organization rela- tive to aspirations and the amount of organizational slack (March and Simon, 1958: 47–52). The direction of search is affected by the location (in the organization) or search activity and the def- inition of the problem stimulating the activity. Thus, the search activity of the organization furthers both the generation of new alternative strategies, and facilitates the anticipation of uncertain futures.

Decision making in the behavioral theory is seen as taking place in response to a problem, through the use of standard operating procedures and other routines, and also through search for an alternative that is acceptable from the point of view of current aspiration levels for evoked goals. Choice is affected, therefore, by the definition of a problem, by existing rules (which reflect past learning by the organization), by the order in which alternatives are considered (which reflects the location of decision making in the organization and past experience), and by anything that affects aspirations and attention.2

Cyert and March (1963) emphasized the uniqueness in firms; organizations and organizational actors differ in terms of their aspi- rations, their knowledge, and their decisions. In terms of relevance to dynamic capabilities, the most basic contribution of the behav-ioral theory of the  firm is  the  importance  of  firm heterogene- ity (Teece et al., 2002), and notions of adaptation (although as discussed later dynamic capabilities have an entrepreneurial as well as an adaptive component). Winter (2000) also uses ideas on satisficing and dynamic aspiration levels to suggest an ecolog- ical and evolutionary perspective in which learning is a dynamic capability.

2. Relationship to Transaction Cost Theory

The transactions cost approach is widely accepted as a framework for understanding aspects of economic organization. This perspec- tive sees markets and hierarchies as alternative mechanisms for organizing economic activity. In order to economize on transaction costs, production is frequently required to be organized in firms. Transaction cost economics builds on the assumptions of bounded rationality and opportunism (Williamson, 1975, 1985). Internal organization is likely to be superior to market transactions when specific assets need to be deployed to get the job done.

There is much utility and some explanatory power in the trans- action cost framework. However, the contractual scheme upon which it is built deals with existing resources and does not examine how new resources are discovered, how they are accumulated, and how firms learn. Opportunism rather than opportunity is the central focus.

The structure and behavior of the modern business firm cannot be fully explained by appealing to transaction costs alone. The focus for the “main case” in transaction cost economics is governance— that is, how things should be organized. Governance is an impor- tant element of management; but good governance alone is unlikely to be sufficient to support sustained competitive advan- tage. While it is important to make good choices with respect to governance (which in Williamson’s definition includes choice of organization boundaries and contractual  arrangements), it  is of equal—if not greater—importance for management to make the right investment choices, select the right assets to “govern”, and establish the correct business model. Superior organizational capabilities require not just astute initial asset selection; they also require continuous reconfiguration and improvement. The trans- action cost framework, by contrast, is primarily about asset or value protection, not value creation.

The way in which governance (choice of firm boundary) issues do come into play in strategic management is well illustrated in Teece (1986a), where there is extensive discussion of comple- mentary assets and whether or not these should be internalized. Deciding whether to “own” or “rent” (i.e. integrate or outsource) complementary assets depends on whether the assets were avail- able in competitive supply. A concern to focus on is the distribution of gains (and losses) between the innovator and the owners of the complementary assets. Williamson also explores appropriability through ex post recontracting. However, the appropriability issues of most concern to business managers do not come from a pure form of what Williamson calls “the fundamental transformation”. With this transformation, an ex ante large numbers bargaining situation is transformed into a small numbers situation after idiosyncratic irre- versible investment assets are deployed, and recontracting hazards result. Rather, it is simply that technological innovation changes the demand for certain inputs (resources) and their complements. The entity that can cleverly bargain to obtain a “long” position in those assets on favorable terms will be able to appropriate a greater share of the gains from innovation. Put differently, in Teece (1986a), it is asset selection based on value creation that shapes firm boundary selection issues—not just the minimization of trans- action costs.

Williamson (1985) clearly recognizes that even in the world of transaction cost economics, governance costs are not the only costs that are relevant to the firm. “Production costs” are indeed men- tioned, but not analyzed deeply. However, much lies hidden within Williamson’s “production costs” that economists and management scholars need to understand. They include not just operational issues, but strategic issues too. Some production-related issues are operational—such as the establishment of flexible procure- ment, enabling the firm to take advantage of changing competitive pricing—and some highly strategic, such as whether or not to invest in a new plant, or whether to advance a new generation of products now, later, or never. Clearly, the performance of a business is going to be very significantly impacted by production and investment choices, as well as by governance choices. For instance, Langlois (1992) highlights the case of the diesel-electric locomotive, where in the 1920s Charles Kettering had developed advanced lightweight diesel technology at the GM Labs. The earli- est use was in submarines. Alfred P. Sloan, GM’s Chairman, saw the possibility of applying the technology to make diesel-electric loco- motives. (Steam power was, at the time, completely dominant.) GM needed capabilities resident in the locomotive manufacturers, and at Westinghouse Electric. As Langlois notes:

The three sets of capabilities might have been combined by some kind of contract or joint venture. But the steam manufacturers—Alco, Baldwin, and Lima—failed to cooperate. This was not, however, because they feared hold-up in the face of highly specific assets. Rather, it was because they actively denied the desirability of the diesel and fought its introduction at every step. General Motors was forced to create its own capabilities in locomotive manufacturer. (p. 115)

The (dynamic) capabilities framework indicates that the scope of the business enterprise’s activities should not be determined solely by transaction cost considerations. Rather, asset selection (intern- alization) decisions must also make reference to opportunity and to complementarities and cospecialization—for position reasons, as well as for reasons of scope economies, and also to achieve appropriability of returns from innovation.

The complementarity between transaction cost economics and dynamic capabilities has been recognized by many, including Williamson, Winter, and the author.3 Williamson notes that trans- action cost and internal firm perspectives “deal with partly overlap- ping phenomenon, often in complementary ways” (1999: 1098). Indeed, the very first empirical study to show the predictive power of asset specificity in setting firm boundaries (Monteverde and Teece, 1982) also showed that even greater predictive power was associated with cospecialization or “systems integration” causing the author (Teece, 1990) to observe that: “[I]n order to fully develop its capabilities, transaction cost economics must be joined with a theory of knowledge and production” (p. 59; also see Winter, 1988).4 As a result, scholars began looking elsewhere to develop more robust theories of the firm. In recent years, the role of product architecture in shaping enterprise architecture has been explored (Teece and Pisano, 2007). Behavioral and evolutionary economics has been recognized as another source of useful insights (Winter, 2003). These traditions also address another, and per- haps deeper, feature of transaction cost theory: that it attempts to explain organizational design issues as fundamentally the result of concerns about opportunism and contractual incompleteness. These are certainly important sets of factors. However, thwarting opportunism and getting incentives right are necessary but not sufficient for superior enterprise performance.

3. Relationship to Evolutionary Theories of the Firm (and Strategy)

The evolutionary theory of the firm goes back to (at least) Alfred Marshall’s construction of industry equilibrium. He saw popu- lations of firms in disequilibrium while industry level supply– demand equilibrium was maintained. He frequently used biological analogies.5 “[F]irms rise and fall”, Marshall said, “but the represen- tative firm remains always of the same size” (1925: 367).

Many ideas significant for the development of the evolutionary view were also introduced by Joseph Schumpeter. For instance, although the idea of rules-based or bounded rationality became associated with Simon (1955) and March and Simon (1958) (and then later embedded in Nelson and Winter, 1982), Schumpeter was early to recognize that bounded rationality is necessary for a theory of innovation and dynamics:

The assumption that conduct is prompt and rational is in all cases a fiction. But it proves to be sufficiently near to reality, if things have time to hammer logic into men. Where this has happened, and within the limits in which it has happened, one may rest content with this fiction and build theories … Outside of these limits our fiction loses its closeness to reality. To cling to it there also as traditional theory does, is to hide an essential thing and to ignore a fact which, in contrast with other devi- ations of our assumption from reality, is theoretically important and the source of the explanation of phenomena which would not exist without it. (Schumpeter, 1934: 80)

Evolutionary ideas also surfaced during the profit maximization debate in economics involving Fritz Machlup, Milton Friedman (1953), Armen Alchian (1950, 1953) and Edith Penrose (1952, 1953). The debate (concerning, among other things, the role of intentionality in economic selection and the use of a population of heterogeneous firms as a basis for selection) led to the formal evolutionary work by Winter (1964, 1971, 1975).6 Despite these prominent predecessors, an evolutionary view of the firm wasn’t developed until decades later. In what was first intended to be entitled “a Neo Schumpeterian Theory of the Firm”, Nelson and Winter (1982) integrated insights from  Schumpeter  with  ideas from Armen Alchain, Friederich Hayek, and Cyert and March (1963). The firm in their view is seen as a profit-seeking entity whose primary activities are to build (through organizational learn- ing processes) and exploit valuable  knowledge  assets.  Firms  in this view also come with “routines” or “competencies”, which are recurrent patterns of action which may change through search and learning. Routines will seldom be “optimal” and will differ among agents, and behaviors cannot be deduced from simply observing the environmental signals (such as prices) that agents are exposed to. The resultant variety drives the  evolutionary  process,  since firms develop rent-seeking strategies on the basis of their routines and competencies, and competition in the product market consti- tutes an important part of the selection environment of competing firms.

In order to fully understand these (and related) issues and their implications for theories of the firm and strategic management, scholars have appealed to the idea of firms as knowledge-creating and learning entities. The firm is seen as endogenously helping to generate its productive opportunity set. This line of thought was developed by Edith Penrose ([1959] 1995) who argued that the firm is a repository of capabilities and knowledge, and that learning is central to firm growth (see Pitelis, 2000, 2006, for a good dis- cussion of Penrose’s work). Productive knowledge is often related to other organizational (material) assets.7 According to Penrose, the firm is “both an administrative organization and a collection of productive resources, both human and material” (p. 320). The services rendered by these resources are the primary inputs into a firm’s production processes and are firm specific in the sense that they are a function of the knowledge and experience that the firm has acquired over time. When services that are currently going unused are applied to new lines of business, these services fuel the growth engine of the firm. Learning enables the organization to use its resources more efficiently. As a result, even firms that maintain a constant level of capital may nevertheless be able to grow as services are freed up for new uses as a result of organizational learning.

My paper on the  multiproduct  firm  (Teece,  1980a:  982)  was the first to apply Penrose’s ideas to strategic management issues. I focused on her observation that human capital in firms is usually not entirely “specialized” and can therefore be  (re)deployed  to allow  the  firm’s  diversification  into  new  products  and  services. I also recognized Penrose’s perspective that firms possess excess resources, which can be used for diversification. Later, Wernerfelt (1984) cited Penrose for “the idea of looking at firms as a broader set of resources . . . [and] the optimal growth of the firm involves a balance between exploitation of existing resources and develop- ment of new ones”.

Perhaps in part because of her training with the economist Fritz Machlup, Penrose was enlightened enough to see a role in economic theory not only for managers but for entrepreneurs. “A theory of the growth of firms is essentially an examination of the changing productive opportunities of firms . . . ” (pp. 31–2). Penrose furthermore saw the business environment as an “image” in the entrepreneur’s mind. This is an important insight about entrepre- neurship as well as leadership (and the importance of having an entrepreneurial element in leadership). Innovation follows in part from the ability of the entrepreneur to look at markets, technolo- gies, and business models and sense opportunities that others miss. Being able to see market and technological opportunities through different lenses (and in new ways) is an important entrepreneurial capability.

Penrose also recognized that as managers embrace growth, they are forced to decentralize, thereby shifting responsibility down the hierarchy. “New men are brought in and the existing personnel of the firm all gain further experience”8 (p. 52). Critically, “many of the productive services created through an increase in knowl- edge that occurs as a result of experience gained in the operation of the firm as time passes will remain unused if the firm fails to expand” (p. 54). These unused resources aren’t manifested in the form of idleness, but “in the concealed form of unused abilities” (p. 54). Penrose therefore saw the capacities of management—not exhaustion of technologically based economies of scale—as setting the limit to which a firm could grow. In her view, there was always a limit to the amount of expansion any firm, no matter how large, could undertake in a given period.

Source: Teece David J. (2009), Dynamic Capabilities and Strategic Management: Organizing for Innovation and Growth, Oxford University Press; 1st edition.

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