The Foundations of Dynamic Capabilities: Escaping the Zero-Profit Condition

The economic theory of (perfect) competition explains that in “equilibrium” firms will make only just enough to cover their cost of capital. This is sometimes referred to as the zero-profit condition. It occurs in the model because there are no points of differentiation amongst firms with respect to technology, markets, information, or skills. With homogeneity amongst firms, and with markets in equilibrium, not a penny of profit is earned beyond that which is necessary to keep the enterprise alive. The (economic) theory of perfect competition does not provide a great deal of guidance for managers, except that it does underscore the result (zero profit) that will occur unless the enterprise can somehow differentiate itself from its competitors and provide a product or service to its customers that is in some way superior to its competitors or cheaper to produce. In this sense it contains an important message; but the theory of (perfect) competition provides few clues as to how best to avoid the zero-profit condition.

The first serious effort to apply economic analysis to strategic management in a systematic and an avowedly normative way was Porter (1980). His Five Forces framework implicitly advised that the way to escape the zero-profit condition and earn supernormal profits was (1) to pick an attractive industry (e.g. one that is grow- ing, faces limited competition, and isn’t exposed to a squeeze from buyers or suppliers), (2) to enter or expand output in that industry while (3) building defenses to shield oneself from competitors who will undoubtedly try and compete away supernormal profits, and leave the enterprise with zero economic profit. Shields available to defend from competition include product differentiation or achiev- ing the lowest cost.

Porter’s Five Forces framework is insightful but limited because it is devoid of any meaningful conceptualization of the firm. With respect to how firms actually differentiate, the Porter framework sees this occurring basically through the product choices they make. There is little attention given to the enterprise itself and its capabilities.

Since Porter, other approaches have emerged. The resources approach anchors differentiation upstream, basically noting that if a firm is going to be able to differentiate its products, it must be dif- ferent in its capabilities and/or business model. This approach was embedded in Penrose’s ([1959] 1995) work. She saw the business enterprises as possessing bundles of fungible resources, generated in part from its prior activities. These resources could be deployed to produce a variety of final products. Managers would endeavor to reconfigure the firm’s portfolio of products so as to meet customer needs. Profits would flow from achieving differentiation and putting excess or unused resources to work (Teece, 1982).

The resources approach provides another way out of the zero- profit trap. Profits can flow from the possession of scarce and difficult to imitate resources or assets, the services of which are in demand by customers. However, the framework is somewhat static in that there is little consideration given to how the firm would sustain the sources of its success. While learning (particu- larly managerial learning) is embedded in the approach, a more robust framework is needed.

A more robust framework is developing with the dynamic capa- bilities approach, which endeavors to explain how firms achieve sustainable competitive advantage in a changing environment exposed to strong competition. Dynamic  capabilities necessar- ily end up identifying organizational (and individual) capabilities that enable the business enterprise to build and maintain value- enhancing points of differentiation. At the heart of the framework is an effort to define managerial traits, management systems, and organizational designs that will keep the enterprise alert to oppor- tunities and threats, enable it to execute on new opportunities, and then constantly morph to stay on top once it has put the systems in place to capture the fruits of its first round of success.

The dynamic capabilities framework contains a richer descrip- tion of features and factors than is contained in Penrose or in the resource-based approach. The framework pulls together many disparate literatures—entrepreneurship, decision theory, organiza- tional behavior, innovation—to identify the key classes of capa- bilities firms must possess if they are to succeed longer term in generating superior profits. It goes further and describes the under- pinnings (microfoundations) too.

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

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