Towards a Capability Theory of (Innovating) Firms: Implications for Management and Policy

Innovating Firms are Key to Capitalism & the Market System:

* It is not the twin theorems of welfare economies but the capabilities that firms have to innovate that makes private enterprise distinctive and superior to socialism.

* Hence, understanding the nature of the business enterprise (“the firm”) and how it innovates is fundamental to the understanding of capitalism.

Learn about these concepts and more, in the context of the dynamic capabilities framework, in this informative and example-filled presentation from Dr. David J. Teece, the founder of dynamic capabilities and the world's most cited scholar in business and management.

David J. Teece is Distinguished Scholar of Strategy and Innovation at the University of South Florida, and Professor of the Graduate School at the University of California, Berkeley. Originally from New Zealand, where he owns Mount Beautiful Winery and several other businesses, Dr. Teece serves as Chairman Emeritus of the Berkeley Research Group, which became majority-owned by Tower Brook partners in February 2025. He is the author of over thirty books and two hundred scholarly papers and co-editor of the Palgrave Encyclopedia of Strategic Management. Dr. Teece has received nine honorary doctorates and has been recognized by Royal Honors. As the world's most cited business and economics professor, his pioneering work on the Dynamic Capabilities Framework has fundamentally shaped how organizations understand competitive advantage in rapidly changing environments.

1. David J. Teece
Chairman, Berkeley Research Group
Thomas W. Tusher Professor in Global Business
Director, Center for Global Strategy & Governance
Faculty Director, Institute for Business Innovation
University of California, Berkeley
New Zealand Association of Economists Distinguished Fellow Award KEYNOTE
July 1, 2016
Auckland University of Technology
Auckland, New Zealand
Copyright David J. Teece 2016 1

2. The business enterprise (“the firm”) is an enabler and the nexus of
innovation in a private enterprise economy (Nelson, 1991).
It is not the twin theorems of welfare economies but the capabilities
that firms have to innovate that makes private enterprise distinctive
and superior to socialism.
Hence, understanding the nature of the business enterprise (“the
firm”) and how it innovates is fundamental to the understanding of
capitalism.
Copyright David J. Teece 2016 2

3. 1.“First theorem”: any competitive equilibrium leads to a
Pareto efficient allocation of resources (invisible hand
theorem)
2.Second fundamental theorem is that any efficient allocation
can be obtained by a competitive equilibrium and by
enacting a lump sum wealth redistribution and letting the
market work
3.Notwithstanding, the importance of capabilities, the
economic theory of the firm still follows the neoclassical
production function approach augmented by agency theory
Copyright David J. Teece 2016 3

4. 1.Coase (1937) and Williamson (1975)
◦Anchored the essence of the firm the entrepreneur- coordinator
who directs production
◦Coase & Williamson saw the relative costs of transactions as
defining firm boundaries
2.Alchian & Demsetz (1972): Nature of the Firm
◦Emphasized teamwork monitoring and coordination
3.Jensen & Meckling (1976)
◦A set of contracting relationships among individuals
Copyright David J. Teece 2016 4

5. Coase himself (1988) pointed out that:
 It is not enough for a theory of the firm to merely explain firm
boundaries

A proper theory of the firm needs to explain why firms develop
capabilities and have different (heterogeneous) costs
The analysis that follows endeavors to fill these voids & remedy inadequacies in the theory of the firm
Some economists have taken up the cudgel regarding capabilities (e.g. Nelson, Winter, & Sutton)
Copyright David J. Teece 2016 5

6. Copyright David J. Teece 2016 6
Contributions by “great
economists”
Subject Matter
Knight (1921) Uncertainty
Marshall (1919) Evolution
Penrose (1955) Resources
Keynes (1936) Animal Spirits
Coase-Williamson (1937, 1975)Transaction Costs

7. Technical efficiency with respect to basic operations (“doing things
right”)
Allows firms to get things done and “make a living” (Winter, 2003).
Requires:
◦Skilled Personnel
◦Facilities & Equipment
◦Routines (“best practices”)
◦Administrative Coordination
However, ordinary capabilities (“best practices”) do not keep
companies competitive for long. Best practices didn’t bring us the
microprocessor, the laser, the steam engine, or even twin headlamps.
Copyright David J. Teece 2016 7

8. Ordinary:
“The operations portion of the automobile business has been
thoroughly optimized over many decades, doesn’t vary much from one
automobile company to another, and can be managed with a focus on
repetitive process. It... requires little in the way of creativity, vision or
imagination. Almost all car companies do this very well, and there is
little or no competitive advantage to be gained by “trying even harder”
in procurement, manufacturing and wholesale.”
Dynamic:
“Where the real work of making a car company successful suddenly turns complex, and where the winners are separated from the losers, is in the long-cycle product development process, where short- term
day-to-day metrics and the tabulation of results are meaningless.”
GM Exec Bob Lutz, 2011
Copyright David J. Teece 2016 8

9. “"If you look at skills, Apple is in a unique and, in my view, unrivaled
position. We have leadership in hardware, software, and services. The
real magic is at the intersection of these. 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” (AFP, 2013)
Apple CEO Tim Cook, February 2013
Copyright David J. Teece 2016 9

10. Copyright David J. Teece 2016 10
Sensing Seizing Transforming

11. Copyright David J. Teece 2016 11

12. Copyright David J. Teece 2016
12
Ordinary (necessary) capabilities Dynamic capabilities
Goals/ Purpose
Technical efficiency in
basic business functions
Achieving congruence with
technological opportunities and market needs
Domain of
applicability
Risk Deep uncertainty
Mode of
attainability
Buy or build (operational learning) Build (dynamic learning and adjustment)
Tripartite schema Operate, administrate, and govern Sense, seize, and transform
Key activities Best practices
Signature (beyond best practice)
processes and activities
Managerial
emphasis
Static optimization
Entrepreneurial asset orchestration
and leadership
Priority Doing things right Doing the right things
Imitability Relatively imitable Relatively inimitable
Tradability (Thick
Markets)
Yes No
Result
Technical fitness / efficiency /
doing things right
Evolutionary fitness / innovation /
doing the right things

13. Clearly distinguishes between “those who open up new and improved methods of business and those who
follow beaten paths”
By contrast, Schumpeter saw managers as little more than superintendents.

Animal spirits are a critical element of investing under uncertainty:
“Most, probably, of our decisions to do something positive, the full consequences of which will be
drawn out over many days to come, can only be taken as a result of animal spirits—of a
spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of
quantitative benefits multiplied by probabilities... Thus if the animal spirits are dimmed and the
spontaneous optimism falters, .... enterprise will fade and die.”
Keynes, 1936, p.161
The Keynesian concept of animal spirits is very consistent with dynamic capabilities.
Jeff Bezos, Amazon CEO & Founder
“There are decisions that can be made by analysis…unfortunately there’s a whole other set of
decisions that you can’t ultimately boil down to a math problem.”
Copyright David J. Teece 2016 13
Marshall’s (1920) principles
Treatise on Probability (Keynes, 1921)

14. Incomplete contracts theory of the firm breaks into:
1.Agency/transactions cost (Grossman, Hart, & Williamson)
2.Theories associated with incomplete (imperfect markets for know-
how) because of “problems” of knowledge acquisition, sharing, and
learning (Malmgren, Richardson, Loasby, & Teece)
Dynamic capabilities builds on the second tradition
•Managers have a critical role in knowledge- based
theories of the firm
Copyright David J. Teece 2016 14

15. Fundamental problem of management is achieving the alignment of
co-specialized assets
Complementarities & their management become center stage
As Samuelson (1974) noted:
“The time is ripe for a fresh modern look at the
concept of complementarity… the last word has
not been said on this ancient preoccupation of
literacy and mathematical economists.” (p. 1255)
Copyright David J. Teece 2016 15

16. Resources/Capabilities “have mouthwatering potential implications”
(Gibbons, 2005)
I.General ◦Managers and entrepreneurs have a place in the (Teeceian) theory
of the firm
◦Knowledge and know-how acquisition, transfer and protection
also find a natural place in the Teeceian theory of the firm
◦Thin markets and non- tradable assets form the essence of the
firm
◦A “transaction cost” problem of a different kind (from Williamson’s TCE) is center stage
◦Firm management is about getting the best out of non- traded and
non-tradable assets
Copyright David J. Teece 2016 16

17. II. Governance (Chandler v. Jensen Perspective)
oManagement matters! Managers aren’t just parasites; they can
build great value
oInfatuation with agency problems and opportunities needs to be
complemented with a focus on opportunity
oManagers play an affirmative role and governance needs to focus
on innovation and good strategy
Resource allocation “problems”
oX-inefficiency: (Leibenstein) weak ordinary capabilities (doing
things wrong is inefficient)
oD-inefficiency: Doing the wrong things. This is horribly inefficient
and is a major strategic issue
Copyright David J. Teece 2016 17

18. Accumulation v. Assimilation Theories
(Capital) v. (Knowledge)
Dynamic capabilities Prioritizes Assimilation
Copyright David J. Teece 2016 18

19. Nelson and Pack (1999):
“If one uses more inputs but does not
innovate and learn, development does not
follow”
Nelson & Pack implicitly endorse a capabilities
perspective
Firms are engines of development
The quality of (entrepreneurial) management really
matters
Copyright David J. Teece 2016 19

20. “Developing countries have a relatively large share of
inefficient, poorly managed firms”
(Bloom, 2012)
This suggests wrong priorities in development policy
Copyright David J. Teece 2016 20

21. The Capabilities Approach is just now starting to garner attention in
economies (already mainstream in management)
Economists have discovered ordinary capabilities (Sutton, Bloom)
Dynamic Capabilities accepted by innovation scholars
With dynamic capabilities, there is a framework for understanding
the role of entrepreneurs and entrepreneurial management in the
economy
At present, too much explanatory burden is place (by default) on the
price system to explain resource allocation
Copyright David J. Teece 2016 21

22. Policy makers are handicapped by the neoclassical (production
function) theory of the firm
Managers are “in absentia” in economic theory, placing too much
burden on the price system to coordinate economic activity
The absence of the manager (in economic theory) leads to:
1.Conceit with respect to the role of the price system… it takes on
an impossible grandiose role
2.Policy makers are stuck with a productive function view of firms
which handicaps their ability to understand development
Economic science cannot aid business and management what as
theory of the firm emerges which has knowledge generation transfer
and management center stage
Capabilities theory aspires to full and embarrassing century old gap
in economic science
Copyright David J. Teece 2016 22