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The Origins, Historical Trajectory andContemporary Applications of theDynamic Capabilities ApproachChair:Welcome:Speakers:Jim Dewald, University of CalgaryElizabeth Cannon, University of CalgaryDavid Teece, University of Calif., BerkeleyBirger Wernerfelt, MIT

DYNAMIC CAPABILITIES: Contemporary Triggers,Classical Antecedents, & Implications for theTheory of the Firm & Strategic Management(abridged version)Professor David J. TeeceTusher Center for Intellectual Capital ManagementHaas School of Business, University of California, BerkeleyStrategic Management Society’s (SMS) Banff 2017 Special Conferenceon Transforming Entrepreneurial Thinking into Dynamic Capabilities*Slides partially based on:1.D.J. TEECE, “TOWARD A CAPABILITY THEORY OF (INNOVATING) FIRMS: IMPLICATIONS FOR MANAGEMENT ANDPOLICY”, CAMBRIDGE JOURNAL OF ECONOMICS, 2017 1 OF 282.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).Copyright D.Teece 20172

I.THE NEED FOR A CAPABILITIESPERSPECTIVE: Empirical“irregularities” & incantations fromNobel Laureates & othersCopyright D.Teece 20173

Heraldic pronouncement from esteemedProf. John Sutton, London School ofEconomics “The proximate cause [of differences in the wealth of nations]lies, for the most part, in the capabilities of firms”(Sutton, 2012: 8)Copyright D.Teece 20174

Top and Bottom Profit Margin Percentiles0.2575th Percentile25th 952000200520100Copyright D.Teece 2017Source: CompustatNotes: Profit margin is defined as EBIT divided byrevenue The sample was restricted to firms with 100million in revenues in at least one of the yearsbetween 1965 and 2014 Revenue field was considered missingwhenever it was zero or negative Industries were defined using manual groupingby the 2-digit SIC code. Quartiles werecalculated across all industries Only years with the minimum number of 20companies were considered Industries included: Multiple Annual data derived from the financialstatements of active and inactive NorthAmerican publicly traded companies. Thesample was restricted to companies with 100million in revenues in at least one of the yearsbetween 1965 and 20145

Largest firms which are also profitability leaders: Isthere increasing liability associated with yright D.Teece 2017Source: CompustatNotes: Fraction of 3 largest firms in each industry (in termsof revenue) which are also in the top (75th)probability percentile across all industries The sample was restricted to firms with 100 millionin revenues in at least one of the years between1965 and 2014 Profit margin is defined as EBIT divided by revenue.Revenue field was considered missing whenever itwas zero or negative Industries were defined using manual grouping by the2-digit SIC code. Quartiles were calculated across allindustries Only years with the minimum number of 20companies were considered Industries included: multiple R-squared 22.73%6

Economists can no longer claim toanalyze income inequality issues whilerelying on black-box models of the firm Wage differences are larger between companies than withinthem (e.g., Barth et al., 2016; Abowd, McKinney and Zhao,2017) Over two-thirds of the increase in earnings inequality from1981-2013 can be accounted for by the rising variance ofearnings between firms Inter-firm wage inequality has become greater and morepersistent as firms increasingly sort themselves into a smallnumber of knowledge-intensive companies and a larger pool ofrelatively labor-intensive firms.Copyright D.Teece 20177

The capability to innovate and change is thevery essence of capitalism, but it is deeplyunderplayed in modern economic theory As Nelson (1981) explains, the very essence of capitalism—infact, the very advantage of a private enterprise economy overa planned one—is that, with private enterprise, firmsinnovate, compete, sometimes disrupt each other, andsometimes cooperate Nelson is surely right; so theories of the firm that do not putinnovation and change center stage are not in tune with theessence of our economy or the fundamental managerialchallenges of our timeCopyright D.Teece 20178

Certain Nobel Laureate economistsexpress deep concern about thecurrent state of academic research “Year after year economic theorists continue to producescores of mathematical models and to explore in greatdetail their formal properties . without being able toadvance, in any perceptible way a systematic understandingof the structure and the operations of a real economicsystem.” (Wassily Leontief, 1982: 107) “Economics as currently presented in textbooks and taughtin the classroom does not have much to do with businessmanagement”, which has “severely damaged both thebusiness community and the academic discipline it is timeto re-engage the severely impoverished field of economicswith the economy” (Ronald Coase, 2012)9Copyright D.Teece 2017

Nobel Laureate Amartya Sen highlightscapabilities Grapples with capabilities, but his focus is on what can be calledordinary capabilities, in contrast to the dynamic capabilities thatare the main focus here Capability framework is articulated more at the level of theindividual, not that of the organization Capabilities are seen as the fulcrum for leveraging tangibleresources into human achievement Recognized that individuals can differ greatly in their abilities toconvert a given set of resources into outputsCopyright D.Teece 201710

II. Antecedents from theclassical economistCopyright D.Teece 201711

Alfred Marshall (the founder of modernmicroeconomics) recognized that managementmatters In Principles, Marshall (1920) recognizes the role ofmanagement in determining enterprise performance Managers fall into those “who open up new and improvedmethods of business and those who follow beaten tracks.” Managers, or “businessmen”, “adventure” or “undertake” therisks (and uncertainties) of business. They bring togethercapital and labor, conduct planning, and superintend to minordetails The manager is “the natural leader of men” (Book IV, ChapterXII, p.173). Marshall notes that good managers are hard tofind, and that management skills tend to atrophyCopyright D.Teece 201712

Frank Knight (1921) hinted at theneed for dynamic capabilities theoryof the firm “With uncertainty present, doing things, the actual execution ofactivity becomes in a real sense a secondary part of life; theprimary problem or function is deciding what to do and how to doit” (Knight, 1921:268) Interpretation: Making the right investments is critical whileoptimizing current activities for efficiency is less important. However, if investments are irreversible, there are potentialproblemsCopyright D.Teece 201713

Lord Keynes (1936) with his appeal to"animal spirits” was perhaps searchingfor a theory of (dynamic) capabilities? Keynes was keenly aware of the importance of firm-level investmentdecisions and long-term investor expectations for macroeconomic theory Invoked “animal spirits” not to signal irrational behavior but to help explaininvestment decisions under uncertainty. Investing requires some kind of “leapof faith” because of the fog of ambiguity around financial outcomesKeynes noted: waiting too long for the future to unfold will often crippledecision making “Most, probably, of our decisions to do something positive, the fullconsequences of which will be drawn out over many days to come, can onlybe taken as a result of animal spirits—of a spontaneous urge to action ratherthan inaction, and not as the outcome of a weighted average of quantitativebenefits multiplied by probabilities. Thus if the animal spirits are dimmedand the spontaneous optimism falters, . enterprise will fade and die.”-Keynes, 1936, p.16114Copyright D.Teece 2017

Lord Keynes & Jeff Bezos (Amazon) seeeye-to-eye Keynes stressed that if human nature felt no temptation totake 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 boildown to a math problem” (Deutschman, 2004, p. 57)Copyright D.Teece 201715

III. Resources & CapabilitiesCopyright D.Teece 201716

Resources: A contribution of heterodoxindustrial economics 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 ofservices that the firm can deploy As theorized by Penrose (1959) a firm at any point in time is likely tohave underemployed resources, including management skills A firm with excess resources will only sometimes find it profitable tomonetize 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 thesense that they are tied to the firmCopyright D.Teece 201717

Dynamic Capabilities Builds on/Accepts ResourceBased View. However: While the resource view is strategic, it is static Each element of VRIN can change over time:Resource-Based ConceptCommentaryV ValuableR RareI Imperfectly immitableN Non-substitutable Bottlenecks can migrate up and down the valuechain, horizontally and laterally, e.g. valuedComputerland’s retail footprint in the 80’s & 90’swas destroyed by Dell’s direct-to-customer businessmodel Patents can expire, products can be reverseengineered New substitutes are being invented constantly, e.g.margarine for butter; electric cars for internalcombustion engine cars18Copyright D.Teece 2017

Observations on the resource-basedapproach How resources are built, coordinated and managed isat least as important to competitive success andsurvival as the identity of the resources themselves Capabilities such as asset orchestration and marketcreation (or co-creation) are vital to profitable“resource” management (Pitelis and Teece, 2010) Whereas the resource based framework can explaincompetitive advantage for the moment, it cannotexplain it over time because it ignores uncertainty Yet, dynamic capabilities requires managers tounderstand VRIN ideas: the frameworks arecomplements, not substitutes“DYNAMIC CAPABILITIES: THE RESOURCE BASED APPROACHON WHEELS & WITH AN ENGINE”19Copyright D.Teece 2017

IV. The critically of the distinctionbetween risks & uncertainty forunderstanding modernmanagement frameworksCopyright D.Teece 201720

Strategic Management requiresdistinguishing between risk B)CDEFAlternative futures with knownprobabilities & known conditionalprobabilitiesCopyright D.Teece 201721

Strategic Management requiresdistinguishing between risk ?F?F?F?Don’t know most futures or their probabilities with (unknownunknowns with probabilities)F 1-4 are possible futuresF? are undefined futures22Copyright D.Teece 2017

Chess v. Mixed Martial Arts (MMA). MMA is agood metaphor for competition underuncertainty in the innovation economyChessEach move is knowable (closed world). The better player almostalways 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 onceobservedMMANot a closed world rules more permissive. Striking, grappling,boxing, kickboxing, Brazilian Jujitsu, Judo, and wresting are allwidely employedCopyright D.Teece 201723

There exists a premium toentrepreneurial management when thereis deep uncertaintyThe lack of predictability and deep uncertainty in MMA is not unliketodays 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, startups versus the banks)To succeed in this world, managers need to be entrepreneurs,and entrepreneurs need to be (or find) managers too (e.g. Brinand Page found Schmidt to be CEO of Google).24Copyright D.Teece 2017

V.The capabilities frameworkgeneralCopyright D.Teece 201725

Strong “ordinary” (or normal)Capabilities: Requires resources to beused efficiently Operations, administration and governance are the focus of ordinarycapabilities Routines / standard operating procedures are key to ordinarycapabilities 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” logic connected to strong ordinary capabilitiesAdmittedly, not everyone gets the simple stuff right26Copyright D.Teece 2017

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 afirm’s success and survival, except in weak competitiveenvironments (which are still ubiquitous in less-developedcountries). Much of the knowledge behind ordinary capabilities can besecured through consultants or through a modest investmentin training (Bloom et al., 2013).Being a top performer in productivity is unlikely togenerate competitive advantages because it onlytakes a few firms at the frontier to drive prices downto competitive levels27Copyright D.Teece 2017

From ordinary to dynamic capabilities inautos Ordinary: The operations portion of the automobile businesshas been thoroughly optimized over many decades, doesn’tvary much from one automobile company to another, and can bemanaged with a focus on repetitive process. It requires little inthe way of creativity, vision or imagination. Almost all carcompanies do this very well, and there is little or nocompetitive advantage to be gained by “trying even harder”in procurement, manufacturing or wholesale Dynamic: Where the real work of making a car companysuccessful suddenly turns complex, and where the winners areseparated from the losers, is in the long-cycle productdevelopment process, where short-term day-to-day metrics andthe tabulation of results are meaningless. -Bob Lutz, former vice chairman at General Motors, Wall Street Journal, June11, 201128Copyright D.Teece 2017

Deep uncertainty (turbulentenvironments) require strong dynamiccapabilities:With stable environments ordinary capabilities are good enough& the VRIN criterion provides meaningful guidance29Copyright D.Teece 2017

Dynamic capabilities can be thought ofas falling in three categories:SensingIdentification ofopportunities &threats at homeand abroadSeizingMobilization ofresources todeliver value andshape marketsTransformingContinuous renewaland periodic majorstrategic shiftsCopyright D.Teece 201730

Sensing is the ability to see aroundcornersThe ability to foresee futureopportunities and threats whatJack Welsh (CEO of GE) once referredto as the ability to “see around thecorners”Copyright D.Teece 201731

Sensing & Black Swans Alert businesses can “discover” the futureahead of the competition “The future is bound to surprise us, butwe don’t have to be dumbfounded”-Kenneth BouldingCopyright D.Teece 201732

Sensing is akin to discovery of the truth“Intellect has little to do on the road to discovery. Therecomes a leap in consciousness, call it intuition or what youwill, and the solution comes to you, and you don’t know howor why.”Albert EinsteinCopyright D.Teece 201733

Good sensing benefits from “abductive”reasoning as a way to help sense thefuture Explanations are developed for surprising oranomalous behavior/phenomenon Induction & deduction depend on the past Abductive reasoning moves ahead through“logical leaps of the mind” and uses allavailable 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 orfalse, but to indicate a new path to “deeptruth” about a phenomenon or a situation34Copyright D.Teece 2017

Other tools to improve sensing Sometimes sensing is enabled by internal R&D activities(“search activities”) and internal scenario planning and othertools to probe the futureInternal R&D can be complemented (but not displaced) bycrowd-sourcing ideas, or by tapping into ideas of customers(Von Hippel), supplies and/or other partnersThe challenge is to develop valid hypothesesabout what is going on in the marketCopyright D.Teece 201735

Seizing/Asset Orchestration is also core todynamic capabilities“Apple still has strong growthopportunities because of its ability towork simultaneously on hardware,software and services Apple has theability to innovate in all three of thesespheres and create magic This isn’tsomething you can just write a checkfor. This is something you build overdecades.”-Tim Cook, Apple CEO (Taipei Times, February 2013)Copyright D.Teece 201736

5: Leadership UndergirdingDynamicmanyCapabilitiesAsset FigorchestrationrequiresskillsSource: Krupp, Steven and Paul J.H. Schoemaker, Winning the Long Game: How Strategic LeadersShape the Future, Public Affairs/Perseus, 2014.Copyright D.Teece 201737

Transformation/Renewal Transformation issues reside between two extremes: On one side it is frictionless organizational world ofmainstream microeconomic theory, in which productiontechnologies can be swapped modified At the other end of the spectrum lies path dependence,captured by the organizational ecology view that somekind of organizational inertia (irreversibility) preventsmost firms from changing in response to existentialstrategic threatsCopyright D.Teece 201738

Irreversibilities: Nobel Laureate KenArrow’s insight Ken Arrow noted: in cases where a commitment is costless reversible,uncertainty poses no problem for the firm (Arrow, 1973) There would be no need to peer into the future because, iftoday’s plan proves unprofitable, the firm can try somethingdifferent tomorrow without penalty There would be no path dependence, and strategic renewalwould be a straightforward affairCopyright D.Teece 201739

Organizational structure & culture Organizational structures, culture, and dynamics create adifferent- and probably more significant irreversibility Dorothy Leonard-Barton (1992) noted that the source of acompany’s strength can become a “core rigidity” that inhibitsits development It is often harder to repurpose an organization than torepurpose a technology. The latter is often little more thanwriting a check; the former requires organizationalreengineeringCopyright D.Teece 201740

Figuring out how to manage/improve theagility/efficiency tradeoff is a hallmark ofstrong dynamic capabilities Agility is the capacity of an organization to efficiently andeffectively redeploy/redirect resources to value creating andvalue protecting activities as internal and externalcircumstances 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 toeffectuate the necessary adjustments would appear to dependon the ability to scan the environment, to evaluate markets andcompetitors, and to quickly accomplish reconfiguration andtransformation ahead of competition” (Teece, Pisano, andShuen, 1997:521)41Copyright D.Teece 2017

Dynamic capabilities emphasizes a specialkind of agility Dynamically capable firms have more than agility and more thanambidexterity Too often, agility is defined as the ability to do commonplacethings faster and cheaper. If that’s what one means by agility, itis more akin to ordinary (rather than dynamic) capabilities When agility refers to a reduction in the time required to reachbest practices, it is simply an incantation for Six Sigma, ValueEngineering, or other efficiency initiatives Those may be necessary for the organization to become moreefficient; but they are only secondarily related to conferringevolutionary fitness What matters most is management’s ability to redeploy physical,financial, and human assets to new and better commercialavenuesCopyright D.Teece 201742

The Tradeoff between Efficiency andAgility is different in Organizations withStrong/Weak Dynamic Capabilities43Copyright D.Teece 2017

The prioritization of ordinarycapabilities can weaken dynamiccapabilities & vice-versa As Benner and Tushman (2003) elegantly stated it as follows:“Activities focused on measurable efficiency and variance reductiondrive out variance-increasing activities and, thus, affect anorganization's ability to innovate and adapt outside of existingtrajectories . Core capabilities may become core rigidities” (Bennerand Tushman, 2003: 242)Copyright D.Teece 201744

Capability/efficiency choices at Pepsi“I had a choice. I could have gone pedal to the metal, strippedout costs, delivered strong profit for a few years, and then saidadios. But that wouldn’t have yielded long term success. So Iarticulated a strategy to the board focusing on the portfolio weneeded to build, the muscles we needed to strengthen, thecapabilities to develop we started to implement that strategy,and we have achieved great shareholder value whilestrengthening the company for the long term.”Indra Nooyi and Adi Ignatius, “How Indra Nooyi Turned Design ThinkingInto Strategy: An Interview with PepsiCo's CEO,” Harvard Business Review(September 2015).Copyright D.Teece 201745

Transformation is about redeployingfinancial, physical, and human resources toeffectuate organizational change What’s needed is some kind of dynamic optimization, ratherthan the static optimization. Lou Gerstner, IBM’s former(turnaround) CEO put it this way:“In anything other than a protected industry, longevity is the capacityto change . If you could take a snapshot of the values and processesof most companies 50 years ago—and did the same with a survivingcompany in 2014—you would say it’s a different company other than,perhaps, its name and maybe its purpose and maybe its industry. Theleadership that really counts is the leadership that keeps a companychanging in an incremental, continuous fashion. It’s constantlyfocusing 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).Copyright D.Teece 201746

Dynamic Vs. Ordinary US Dynamic sPurpose Technical efficiency in basicbusiness functions Strategic “fit” over the long run(evolutionary fitness)Tripartiteschemes Operational, administrative,and governance Sensing, seizing, shaping andtransforming Difficult ; inimitableImitability Relatively easy; imitableDoing things “right”Doing the “right” things47Copyright D.Teece 2017

VI. Capabilities and StrategyCopyright D.Teece 201748

Congruence (with strategy & capabilities)is important, and general systems theoryalerted us to this 50 years ago Systems theory views organizations as social systems existing indifferent environments with units that must be associated if theorganization is to be effective (Churchman, 1968) The underlying logic was later redeveloped into a pragmaticmodel of organizational alignment by Nadler and Tushman The Nadler-Tushman framework might be lacking some criticalcomponents. A business model, for example, defines thearchitecture of a business, specifying the value proposition to thecustomer and how the delivery of value is to be monetized(Teece, 2014). Is missing from their frameworkEVEN IF ALL INTERNAL COMPONENTS FIT WELL TOGETHER,THE ORGANIZATION MAY FAIL IF IT DOESN’T FIT WHAT THEMARKET REQUIRE AND ITS BUSINESS MODEL IS MISSPECIFIED49Copyright D.Teece 2017

Strategy is complementary to dynamiccapabilities“A good strategy is a ‘specific’ and ‘coherent’ response to—and approach forovercoming—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)DiagnosisGuiding policyCoherent actionCopyright D.Teece 201750

“Resources” (number & tonnage of warships) isn’tdecisive: Stalemate at the Battle of Jutland wherestrategy was absentThe British Navy at theBattle of Jutland, 1916“There seems to besomething wrong with ourbloody ships today.”Admiral John Jellicoe“The real deficiency, however, was theloss of [Vice Admiral Horatio Lord]Nelson’s touch. It was not the bloodyships that were principally at fault. Itwas the inadequate doctrine ofcommand and control.”Frank Hoffman, “What we can learn from Jackie Fisher,”Proceedings of the Naval Institute, April 2004, p. 70.51Copyright D.Teece 2017

Aligning agility & strategy – The Battle of TrafalgarCopyright D.Teece 201752

VII. Enhancing/modifyingcapabilities & closing capabilitygapsCopyright D.Teece 201753

Closing capability “gaps” Capability gaps are of at least three kinds: Technology gaps Market gaps Business model gapsCopyright D.Teece 201754

Recognizing capability gaps isn’tstraight forward The first challenge is to understand the location andmagnitude of capabilities deficiencies Often it is only after an organization tries to dosomething (and fails) that the gap is apparent. Theearly phase of a project looks okay because there aretypically few outcomes metrics to evaluate Later on, problem begin to crop up, the senior teamgets more and more involved, and the goal slips furtheraway Ad hoc “solutions” are attempted and failed. Only thenis there general recognition of a capability gapCopyright D.Teece 201755

There may or may not be a resource gapbehind 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 meansthat benefits can flow from entrepreneurial and managerialactivity that builds and hones value-creating capabilitiesCopyright D.Teece 201756

Organizational hubris tend to compelthe exaggeration of currentcapabilities The search for capability gaps begins by examining the matchbetween a proposed business model and the firm’s existingcapabilities An analysis of existing capabilities needs an objective point ofview that is detailed and realisticCopyright D.Teece 201757

Capability gaps & the transformation challengeMarket DistanceTarget state relative to current “O”Current stateOTechnological DistanceBusiness Model Distance57

VII. Dynamic capabilities & competingapproaches to the theory of thefirmCopyright D.Teece 201759

DeepUncertaintyThe evolution of strategic management & “research based”thinkingDynamicCapabilitiesRBVRisk5 ForcesPlanning-1-5 yearbudgets- Risk control-Market forecasts-Limitedcompetitiveanalysis1960sCopyright Teece 20161980s-industryattractiveness isthe centralfocus-Entry barrierscritical-Shielding fromcompetitors is thegame changer1990s-VRIN assetsdrive valuecreation- 4 VRINtraits necessary tosustain advantage“Isolatingmechanisms”arecentral-Asset orchestration& strategy helpdrive advantage-Reshapingecosystems & bizmodels is criticalDecision makingunder deepuncertaintyIdentifying &bridging capabilitygaps2000 60

A taxonomy of relevant theories There are at least three classes of (economic) theories of thefirm:1.Production functions perspective2.Incomplete contracts and agency3.Knowledge and capabilities. Dynamic capabilities belongsto this class It is also recognized by some observers that both economic andstrategic management perspectives are needed for a robusttheory of the firm As Oliver Williamson (1999, p. 1106) observed, the twoapproaches (transaction costs and capabilities) are “both rivaland complementary more the latter than the former”Copyright D.Teece 201761

The dynamic capabilities frameworkas General Systems Theory Redux? Brings Knightian uncertainty, Marshallian evolution, Penroseanresources, Schumpeterian creative destruction, Keynesian“animal spirits,” and Coase-Williamsonian transaction costsand Boulding’s (1956) General Systems Theory together It can potentially explain not only why firms exist, but alsotheir scope and potential for growth and sustainedprofitability in competitive markets riddled with deepuncertaintyCopyright D.Teece 201762

Connections to economics: Invisible &Visible hand theories “Neoclassical theory’s objective is to understand price-guided,not management-guided, resource allocation” (Demsetz, 1997:426). This focus is a major limitation as it deflects attentionfrom critical resource allocation decisions inside firms In particular, economists have been silent on criticalmanagerial issues such as: (i) how firms innovate (beyond justspending money on R&D); (ii) why firms have capabilities thattranscend the sum of individual skills of their employees andcontractors; (iii) how individual firms sustain competitiveadvantage over rivals Capabilities theory falls into visible hand theories. Visible handtheories address resource allocation processes inside the firmVisible & invisible hand theories arecomplementaryCopyright D.Teece 201763

Paul Romer: The field of economicsneeds disruption (from the strategyfield)? “A research program ought to involve risk” (Romer, forthcoming) Dynamic capabilities is a radical approach to the theory of thefirm that puts capabilities and not the

Computerland’sretail 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 18