Dynamic Capabilities: What Are They And How They Can Be Applied

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 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 e v olution of strat e gic management & “research based” t hinking 5 Forces * I ndustry attracti v eness is the central focus E xternal forces do m inate F ate = s tatic, purely co m petiti v e m arkets ( low profit) RBV ** VRIN as s ets dri v e value creation B ar r iers to compet i tion determine longevity A ll 4 VRIN traits ne c essary to s ustain ad v antage Dynam ic Capa b i l it i es *** M arke t s are d y nam i c and co m petiti o n is of t en disrupti v e Asset orchestration & strategy dri v e ad v ant a ge Reshaping ecos y stems & biz mo d els is critical 1980s 1990s 2000+ The Dyna m ic Capab i lity m odel is only the third sub s tant i ve fra m ework for m ainta i ning c o m pet i tive ad v antage to e m erge 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 1 Teece, 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 Categories 1 : 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 1 See 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 Activities 1 Shifting Activities 1 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 Imitability 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 o f 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 matter 1 Where is the bottleneck in the go-to-market value chain? Is it manufacturing? What is the business model to let the innovator control the bottleneck? Bottlenecks can be proprietary standards, intellectual property, and/or complementary assets such as manufacturing. Outsourcing is okay, but only when manufacturing isn’t the bottleneck now and is unlikely to be in the future. 24 1 See 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/Competitors 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