Dynamic Capabilities: Nature and Microfoundations (2007) PDF

Strategic Management Journal Strat. Mgmt. J., 28: 1319–1350 (2007) Published online 7 August 2007 in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/smj.640...

Strategic Management Published online EXPLICATING DYNAMIC AND MICROFOUNDATIONS ENTERPRISE PERFORMANCE DAVID J. TEECE* Institute of Management, University of California, This paper draws and microfoundations in an open economy tion, and manufacturing deploy, and protect The microfoundations nizational structures, seizing, and reconfiguring dynamic capabilities but also shape ties, and institutions. long-run enterprise and the priorities tendency associated John Wiley & INTRODUCTION Recent scholarship stresses that business enter- prises consist of portfolios of idiosyncratic and difficult-to-trade assets and competencies (’re- sources’).1 Within this framework, competitive advantage can flow at a point in time from the ownership of scarce but relevant and difficult-to- imitate assets, especially know-how. However, in Keywords: cospecialization; intangible assets; innovation; business ecosystems; entrepreneurship; managerial capi- talism; global competitiveness *Correspondence to: David J. Teece, F402 Business #1930, University of California, 94720-1930, U.S.A. E-mail: [email protected] through enhancing, combining, protecting, and, when necessary, reconfiguring the business enter- (1984), Amit prise’s intangible and tangible assets. Dynamic capabilities include difficult-to-replicate enterprise that multiple inventions must be combined to cre- ate products and/or services that address customer needs. The third is that there are well-developed global markets for the exchange of (component) goods and services; and the fourth is that the busi- ness environment is characterized by poorly devel- oped markets in which to exchange technological and managerial know-how. These characteristics can be found in large sectors of the global econ- omy and especially in high-technology sectors. In such sectors, the foundations of enterprise success today depend very little on the enterprise’s abil- ity to engage in (textbook) optimization against known constraints, or capturing scale economies in production. Rather, enterprise success depends upon the discovery and development of opportuni- ties; the effective combination of internally gener- ated and externally generated inventions; efficient and effective technology transfer inside the enter- prise and between and amongst enterprises; the protection of intellectual property; the upgrading of ‘best practice’ business processes; the inven- tion of new business models; making unbiased decisions; and achieving protection against imita- tion and other forms of replication by rivals. It also involves shaping new ‘rules of the game’ in the global marketplace. The traditional elements of business success—maintaining incentive align- ment, owning tangible assets, controlling costs, maintaining quality, ‘optimizing’ inventories—are necessary but they are unlikely to be sufficient for sustained superior enterprise performance. Executives seem to recognize new challenges in today’s globally competitive environments and understand how technological innovation is nec- and inte- essary but not sufficient for success. A. J. Lafley, CEO of Proctor & Gamble, notes that ‘the name capabil- of the game is innovation. We work really hard to enter- try to turn innovation into a strategy and a process that... ‘.3 Sam Pamisano, CEO of IBM, remarks that is that the ‘innovation is about much more than new prod- ucts. It is about reinventing business processes and asso- building entirely new markets that meet untapped customer demand.’4 Put differently, there is an emerging recognition by managers themselves that the foundations of enterprise success transcend simply being productive at R&D, achieving new analogous to that of product introductions, adopting best practice, and constantly being created, delivering quality products and services. Not only new instru- ones need to be 3 an element of orches- Fortune, December 11, 2006: 4. 4 Business Week, April 24, 2004: 64. Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1321 new markets to emerge; and as discussed later, the ubiquity of ‘platforms’ must now be recognized (Evans, Hagiu, and Schmalensee, 2006). While the development and astute management of intangible assets/intellectual capital is increas- ingly recognized as central to sustained enter- prise competitiveness, the understanding of why and how intangibles are now so critical still remains opaque and is not addressed by orthodox frameworks. What is needed is a new framework for business and economic analysis. As former U.S. Federal Reserve Chairman Alan Greenspan remarked, ‘we must begin the important work of developing a framework capable of analyzing the growth of an economy increasingly dominated by conceptual products.’5 The dynamic capabilities approach developed here endeavors to be respon- sive to this challenge at the enterprise level. In an earlier treatment (Teece et al., 1997: 530) it was noted that ‘we have merely sketched an out- line for a dynamic capabilities approach.’ In what follows, the nature of various classes of dynamic capabilities is identified, and an effort is made to separate the microfoundations of dynamic capa- bilities from the capability itself. Put differently, important distinctions are made between the orga- nizational and managerial processes, procedures, systems, and structures that undergird each class of capability, and the capability itself. One should note that the identification of the microfounda- tions of dynamic capabilities must be necessarily incomplete, inchoate, and somewhat opaque and/or their implementation must be rather difficult. Oth- erwise sustainable competitive advantage would erode with the effective communication and appli- cation of dynamic capability concepts. Of course, the existence of processes, proce- dures, systems, and structures already ubiquitously adopted by competitors does not imply that these have not in the past been the source of competitive advantage, or might not still be a source of compet- itive advantage in certain contexts. For example, studies of the diffusion of organizational innova- tions (e.g., Armour and Teece, 1978; Teece, 1980) and 5 Chairman Alan Greenspan also noted recently, ‘over the past half century, the increase in the value of raw materials has accounted for only a fraction of the overall growth of U.S. gross domestic product (GDP). The rest of that growth reflects the embodiment of ideas in products and services that consumers value. This shift of emphasis from physical materials to ideas as the core of value creation appears to have accelerated in recent decades.’ (Remarks of Alan Greenspan, Stanford Institute for Economic Policy Research, 2004.) Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj by Kirzner (1973), entrepreneurs can have differ- ential access to existing information. Second, new information and new knowledge (exogenous or endogenous) can create opportunities, as empha- sized by Schumpeter (1934). Kirzner stressed how the entrepreneurial function recognizes any dise- quilibrium and takes advantage of it. The Kirzner- ian view is that entrepreneurship is the mechanism by which the economy moves back toward equi- librium. Schumpeter, on the other hand, stressed upsetting the equilibrium. As Baumol (2006: 4) notes, ‘the job of Schumpeter’s entrepreneur is to destroy all equilibria, while Kirzner’s works to restore them. This is the mechanism under- lying continuous industrial evolution and revolu- tion.’ Equilibrium is rarely if ever achieved (Shane, 2003). Both forces are relevant in today’s econ- omy. To identify and shape opportunities, enterprises must constantly scan, search, and explore across technologies and markets, both ‘local’ and ‘dis- tant’ (March and Simon, 1958; Nelson and Winter, 1982). This activity not only involves investment in research activity and the probing and reprob- ing of customer needs and technological possibili- ties; it also involves understanding latent demand, the structural evolution of industries and mar- kets, and likely supplier and competitor responses. To the extent that business enterprises can open up technological opportunities (through engaging in R&D and through tapping into the research output of others) while simultaneously learning about customer needs, they have a broad menu of commercialization opportunities. Overcoming a narrow search horizon is extremely difficult and costly for management teams tied to established problem-solving competences. Henderson (1994) notes that General Motors (GM), IBM, and Dig- ital Equipment Corporation (DEC) encountered difficulties because they became prisoners of the deeply ingrained assumptions, information filters, and problem-solving strategies that made up their world views, turning the solutions that once made them great into strategic straitjackets. When opportunities are first glimpsed, entrepre- neurs and managers must figure out how to inter- pret new events and developments, which tech- nologies to pursue, and which market segments to target. They must assess how technologies will evolve and how and when competitors, suppli- ers, and customers will respond. Competitors may or may not see the opportunity, and even if they Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1323 assessing customer needs, expressed and latent. It involves learning, interpretation, and creative activity. While certain individuals in the enterprise may have the necessary cognitive and creative skills, the more desirable approach is to embed scan- ning, interpretative, and creative processes inside the enterprise itself. The enterprise will be vulner- able if the sensing, creative, and learning functions are left to the cognitive traits of a few individuals.6 Organizational processes can be put in place inside the enterprise to garner new technical information, tap developments in exogenous science, monitor customer needs and competitor activity, and shape new products and processes opportunities. Infor- mation must be filtered, and must flow to those capable of making sense of it. Internal argument and discussion about changing market and tech- nological reality can be both inductive and deduc- tive. Hypothesis development, hypothesis ‘testing,’ and synthesis about the meaning of information obtained via search are critical functions, and must be performed by the top management team. The rigorous assembly of data, facts, and anecdotes can help test beliefs. Once a synthesis of the evidence is achieved, recurrent synthesis and updating can be embedded in business processes designed by middle management and/or the planning unit in the business organization (Casson, 1997). If enter- prises fail to engage in such activities, they won’t be able to assess market and technological devel- opments and spot opportunities. As a consequence, they will likely miss opportunities visible to others. As noted in Teece et al. (1997), more decen- tralized organizations with greater local autonomy are less likely to be blindsided by market and technological developments. Because of the prob- lem of information decay as information moves up (and down) a hierarchy, businesses must devise mechanisms and procedures to keep management informed. Bill Hewlett and David Packard devel- oped ‘management by walking about’ (Packard, chart, 1995) as a mechanism to prevent top management news of at Hewlett-Packard from becoming isolated from or the One must 6 In a limited sense, that is about decision making under uncer- tainty. As Knight observes, with uncertainty there is ‘a necessity to act upon opinion rather than knowledge’ (Knight, 1921: 268). The problem is not just about knowledge asymmetries and incen- tive problems as Alchian and Demsetz (1972) seem to suggest. Rather, it involves filtering and interpreting information about evolving technologies and marketplaces. Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj technology/components in a timely fashion will lend to failure; conversely, success can some- times be achieved by continuous rapid ‘design in.’ Indeed, continuous and rapid design around new technology/components developed elsewhere can itself be a source of durable competitive advan- tage. Put differently, with rapid innovation by com- ponent suppliers, downstream competitive success can flow from the ability of enterprises to continu- ously tap into such (external) innovation ahead of the competition. External search and acquisition of technology have been going on for decades, but as Chesbrough (2003) explains, ‘Open Innovation’ is now a mandate for enterprise success. The concept and practice of open innovation underscore the importance of broad-based external search and subsequent integration involving cus- tomers, suppliers, and complementors. Establish- ing linkages between corporations and universities assists broad-based search, as university programs are usually unshackled from the near at hand. Indeed, a recent study of patenting in the opti- cal disk industry (Rosenkopf and Nerkar, 2001) seems to suggest that exploration that is more con- fined generates lower impacts, and that the impact of exploration is highest when exploration spans organizational (but not technological) boundaries. However, it is not just a matter of searching for external inventions/innovations that represent new possibilities. Frequently it is a matter of combining complementary innovations so as to create a solu- tion to a customer problem. The systemic nature (Teece, 2000) of many innovations compounds the need for external search. Sensing opportunities and threats can also be facilitated if the enterprise and/or the entrepreneur explicitly or implicitly employ some kind of ana- lytical framework, as this can help highlight what is important. The field of strategic management has been stranded for some time with a frame- work that implicitly assumes that industry struc- ture (and product market share), mediated by enterprise behavior, determines enterprise perfor- mance. In Porter’s (1980) Five Forces frame- work, a good strategy involves somehow picking an attractive industry and positioning oneself to be shielded from competition. Porter’s approach mandates ‘industry’ analysis7 and the calibration of five distinct industry-level forces: the role of 7 The Five Forces framework undergirds ‘industry’ analysis in business school curriculum and in practice. However, the very Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1325 game,’ (b) for factors inside the business enter- prise that constrain choices, (c) for factors that impact imitation and appropriability issues, (d) for the role of supporting institutions, complementary assets, cospecialization, and network externalities, or (e) for the blurred nature of industry boundaries. Also, as discussed later, in many ‘platform’ indus- tries or where there is significant outsourcing, scale is an industry asset. The dynamic capabilities framework represents a strong break with Five Forces. Within the dynamic capabilities framework, the ‘environmen- tal’ context recognized for analytical purposes is not that of the industry, but that of the busi- ness ‘ecosystem’—the community of organiza- tions, institutions, and individuals that impact the enterprise and the enterprise’s customers and sup- plies. The relevant community therefore includes complementors, suppliers, regulatory authorities, standard-setting bodies, the judiciary, and educa- tional and research institutions. It is a framework that recognizes that innovation and its support- ing infrastructure have major impacts on com- petition. The dynamic capabilities framework is grounded in Kirznerian, Schumpeterian, and evolu- tionary theories of economic change, whereas Five Forces is grounded in the Mason–Bain paradigm of industrial economics.9 Also, whereas according to Porter the essence of strategy formulation is ‘coping with competition’ (Porter, 1991: 11), in the dynamic capabilities tradition the essence of strat- egy involves selecting and developing technolo- gies and business models that build competitive advantage through assembling and orchestrating difficult-to-replicate assets, thereby shaping com- petition itself. Even when utilizing the ecosystem as the orga- nizing paradigm for assessing developments in the business environment, the full import of particular facts, statistics, and developments is rarely obvi- ous. Accordingly, the evaluative and inferential value. If indus- least in technologically skill possessed by an organization and its manage- the telecommunications ment is important. Indeed, much of the informa- over half a cen- tion gathered and communicated inside the enter- and associated prise has minimal decision relevance. Even if rel- public telephone net- evant, it often arrives too late. Management must by the Internet (using find methods and procedures to peer through the performance 9 Developed in the 1930s, 1940s, and 1950s, it is still relevant to some of the ‘rust belt’ industries that experience low rates of to recognize that cau- technological innovation where complementors are not impor- with market structure tant, and where the coevolution of technologies and institutions is not significant (Teece, 1990). Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Processes to Tap Developments in Exogenous Science and Technology. Analytical Systems (and Individual Capacities) to Learn and to Sense, Filter, Shape, and Calibrate Opportunities. Processes to Identify Target Market Segments, Changing Customer Needs, and Customer Innovation. framework for ‘sensing’ market and technological opportunities and Suarez, 1993; Malerba and Orsenigo, 1996). It implicitly recognizes inflexion points in tech- nological and market evolution. These inflexion points impact investment requirements and strate- gic choices. Implications for investment decisions have been noted elsewhere (Teece, 1986) and include staying flexible until the dominant design emerges and then investing heavily once a design looks like it can become the winner. Any strat- egy is, of course, likely to be fraught with hazards because of uncertainties. Moreover, the manner and time at which an enterprise needs to place its bets depend on competition in the ‘input’ markets and on the identity of the enterprise itself. Mitchell (1991) suggests that the timing of resource com- mitments can differ according to the enterprise’s existing positions with respect to the relevant com- plementary assets. Enterprises that are well posi- tioned can wait, while those that are not must scramble. Addressing opportunities involves maintaining and improving technological competences and complementary assets and then, when the opportu- nity is ripe, investing heavily in the particular tech- nologies and designs most likely to achieve mar- ketplace acceptance. When network externalities are present, early entry and commitment are nec- essary. The presence of increasing returns means that if one network gets ahead, it tends to stay ahead. Getting ahead may require significant up- front investments. Customers will not want an enterprise’s products if there are strong network effects and the installed base of users is rela- tively small. Accordingly, one needs to strategize around investment decisions, getting the timing right, building on increasing return advantages, and leveraging products and services from one applica- tion to another. The capacity to make high-quality, Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1327 future cash flow can be confidently projected. In short, the new can lose out to the established unless management is sensitive to the presence of cer- tain biases in accepted investment decision pro- cesses. An important class of dynamic capabilities emerges around a manager’s ability to override certain ‘dysfunctional’ features of established deci- sion rules and resource allocation processes. It helps to begin by recognizing that decision- making processes in hierarchically organized enter- prises involve bureaucratic features that are use- ful for many purposes, but they nevertheless may muzzle innovation proclivities. In particular, a for- mal expenditure process involving submissions and approvals is characteristic of ‘well-managed’ companies. Decision making is likely to have a committee structure, with top management requir- ing reports and written justifications for signif- icant decisions. Moreover, approvals may need to be sought from outside the organizational unit in which the expenditure is to take place. While this may ensure a matching up of expenditures to opportunities across a wider range of economic activity, it unquestionably slows decision making and tends to reinforce the status quo. Commit- tee decision-making structures almost always tend toward balancing and compromise. But innovation is often ill served by such structures, as the new and the radical will almost always appear threat- ening to some constituents. Strong leaders can fre- quently overcome such tendencies, but such lead- ers are not always present. One consequence is a ‘program persistence bias.’ Its corollary is various forms of ‘anti-innovation bias,’ including the ‘anti- cannibalization’ basis discussed in a later section. Program persistence refers to the funding of pro- grams beyond what can be sustained on the merits, and follows from the presence or influence of pro- gram advocates in the resource allocation process. This proclivity almost automatically has the coun- tervailing effect of reducing funds available to new initiatives. One should not be surprised, therefore, if an enterprise senses a business opportunity but fails to invest. In particular, incumbent enterprises tend to eschew radical competency-destroying innova- tion in favor of more incremental competency- enhancing improvements. The existence of layer upon layer of standard procedures, established capabilities, complementary assets, and/or admin- istrative routines can exacerbate decision-making biases against innovation. Incumbent enterprises, Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj quality of the enterprise’s routines, decision rules, strategies, and leadership around evaluating new investment opportunities. Business historians (e.g., Chandler, 1990a; Lazonick, 2005) and others have reminded us that over the long run the ability of enterprises to commit financing and invest astutely around new technologies is critical to enterprise performance.10 In regimes of rapid technological innovation, it is clear that making investment choices requires special skills not ubiquitously distributed amongst management teams. Nor are they ubiquitously dis- tributed amongst investors.11 Resource/asset align- ment and coalignment issues are important in the context of innovation, but they are quite different from portfolio balance issues faced by financial investors. The presence of increasing returns means that one also needs to strategize around investment decisions, getting the timing right, building on increasing return advantages, and leveraging products and services from one appli- cation to another. Value-enhancing investments inside the knowledge-based enterprise are often cospecialized12 to each other. Also, the nature of the portfolio ‘balance’ needed inside the enterprise is different from the portfolio balance sought by pure financial investors. The economics of cospe- cialization are not the economics of covariance with which investors are familiar. In short, the task of making astute project- and enterprise-level investment decisions is quite challenging because of cospecialization, and irreversibilities. The project finance and related literatures pro- vide tools and clear decision rules for project selection once cash flows are specified, uncertainty and/or risk are calibrated, and interdependencies 10 Consider the development of civilian jet transport aircraft in the United States in the 1950s. As Phillips (1971: 126) noted: ‘Any one of Boeing, Douglas, Lockheed, or Corvair might have been first.... The technology was there to adapt to—not risklessly or costlessly to be sure, but it was there. Perhaps the biggest risk in 1953 was not technological in character. Instead, it was risk with respect to what sort of jet to build and when to build it.’ 11 The decision skills required of management have limited commonality with those of an investor. One difference is the illiquidity and irreversibility of most managerial investment decisions. Another is the need to achieve continuous alignment amongst the assets at work in the enterprise. Both public and private equity investors typically lack this kind of orchestration and integration capability or capacity. Moreover, their skills are most applicable when investments are liquid. 12 Cospecialization is defined and discussed in Teece (1986) and explored further in the section below entitled ‘Managing threats and reconfiguration.’ Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1329 apparent. No matter how much analytical work is done, tacit investment skills are of great impor- tance. Chandler further argues that success in the late-nineteenth and much of the twentieth century came to those enterprises that pursued his ‘three- pronged’ strategy: (1) early and large-scale invest- ments behind new technologies; (2) investment in product-specific marketing, distribution, and pur- chasing networks; and (3) recruiting and organiz- ing the managers needed to supervise and coordi- nate functional activities. The first and second ele- ments require commitment to investments where irreversibilities and cospecialization are identified. While the nature of required investments may have changed in recent decades (less decompos- able/more interrelated), investment decision skills remain important. Microfoundations Selecting product architectures and business models The design and performance specification of prod- ucts, and the business model employed, all help define the manner by which the enterprise deliv- ers value to customers, entices customers to pay for value, and converts those payments to profit. They reflect management’s hypothesis about what customers want and how an enterprise can best meet those needs, and get paid for doing so. They embrace: (1) which technologies and features are to be embedded in the product and service; (2) how the revenue and cost structure of a business is to be ‘designed’ and if necessary ‘redesigned’ to meet customer needs; (3) the way in which technolo- gies are to be assembled; (4) the identity of market segments to be targeted; and (5) the mechanisms and manner by which value is to be captured. The function of a business model is to ‘articu- late’ the value proposition, select the appropriate technologies and features, identify targeted market segments, define the structure of the value chain, and estimate the cost structure and profit potential (Chesbrough and Rosenbloom, 2002: 533–534). In of the automobile indus- short, a business model is a plan for the organi- considerations impacted zational and financial ‘architecture’ of a business. at the value to be protocols likely to aid This model makes assumptions about the behav- Evans, Hagiu, and ior of revenues and costs, and likely customer and competitor behavior. It outlines the contours of the . solution required to earn a profit, if a profit is avail- examined uncertainty has received very able to be earned. Once adopted it defines the way the enterprise ‘goes to market.’ Success requires Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj other dot-coms demonstrated just the opposite). Both Dell Inc.’s and Wal-Mart’s business models were different, superior, and hard for competitors to replicate. They have also constantly adjusted and improved their processes over time.16 One might be tempted to argue that designing, implementing, and validating business models is straightforward, but this simply is not so. Aspects of designing (and redesigning) a business model are undoubtedly readily routinized and codified. Note the plethora of business books providing instruction on how to write a business plan. Such manuals can provide some discipline to the busi- ness model questions that one should ask. How- ever, designing a new business requires creativity, insight, and a good deal of customer, competitor, and supplier information and intelligence. There is a significant tacit component. Entrepreneurs and executives are forced to make many informed guesses about customer and competitor behavior, as well as the behavior of costs. Indeed, validat- ing a business model and a business plan requires both effort and judgment. It takes detailed fact- specific inquiry including: a keen understanding of customer needs and customer willingness to pay; an understanding of procurement cycles and the sales cycle; knowledge of supply and distribution costs; and an understanding of competitor position- ing and likely competitive responses. Put differ- ently, selecting the right ‘architecture’ for a busi- ness requires not just understanding the choices available; it also requires assembling the evidence needed to validate conjectures and hunches about costs, customers, competitors, complementors, dis- tributors, and suppliers. Designing good business models is in part ‘art.’ However, the chances of success are greater if enterprises (1) analyze multiple alternatives, (2) have a deep understanding of user needs, (3) analyze the value chain thoroughly so as to understand just how to deliver what the customer wants in a cost-effective and timely fashion, and might decide to use (4) adopt a neutrality or relative efficiency per- spective to outsourcing decisions. Useful tools The star could include market research and transaction cost eco- concerts, and more time nomics. Chesbrough and Rosenbloom (2002) sug- gest that established enterprises often have blinders virtual stores such The emergence of 16 in turn requires artists Indeed, a critical element of Dell’s success is not just the way it has organized the value chain, but also the products that delivering and pricing it decides to sell through its distribution system. The initial products were personal computers, but now include printers, digital projectors, and computer-related electronics. Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1331 stream, downstream, as well as externally, is partly driven by the need to build capabilities, particularly when such capabilities are not widely distributed in the industry. Of course, vertical spe- cialization is not itself independent of enterprise strategy, and vice versa (Macher and Mowery, 2004). Studies of the early vertical evolution of the petroleum industry stressed the need to align upstream and downstream capacities in an envi- ronment where qualified business partners were limited (Teece, 1976). Pisano, Shan, and Teece (1988: 202) developed a framework for under- standing R&D outsourcing that recognized that the locus of world-class research/productive capabil- ity might lie external to the enterprise, requiring outsourcing as a way to compete.19 Jacobides and Winter (2005: 398) have also clearly stated that ‘it is necessary to look at the distribution of produc- tive capabilities—to understand when enterprises are integrated and when they are not. It becomes clear that vertical specialization must be in part a function of heterogeneity in productive capabili- ties along the value chain.’ They also note that the capability development process itself changes as a consequence of changing scope. Recognition that systemic innovation favors integration, for both transaction costs and capability reasons, is also embedded in the saga of the development of the diesel electric locomotive (Teece, 1988). The abil- ity of enterprises to procure technology externally as well as develop it internally are critical skills, as discussed above and in Teece (1986), Ches- brough and Teece (1996), and Teece (2000). Firms must dispel prejudices against technology from the outside, and hone their absorptive capacity through learning activities and skill accumulation. Enterprises may require alliance arrangements to actively learn and upgrade relevant skills (Branzei and Vertinsky, 2006). The critical strategic element associated with capturing value from innovation is the ability of the innovating enterprise to identify and control the ‘bottleneck assets’ or ‘choke points’ in the value chain from invention through to market (Teece, 1986, 2006). Outsourcing those assets/services that model is exem- exclusively on patent 19 technological con- The model identified transaction costs, the locus of capabilities memory devices. Such (inside or outside the enterprise), and appropriability regimes as three relevant classes of factors driving enterprise boundary entirely on Ram- decisions. In particular, it was noted that transaction cost factors an environment in which ‘must be weighed against any losses in productive efficiency that result from being less skilled than specialists in the relevant stages of production.’ Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj ‘products’ are often systems. These systems con- sist of interdependent components resting on ‘plat- forms.’ There is strong functional interdependence amongst components of the system. End user demand is for the system, not the platform. There is often a multisided ‘market’ phenomenon at work as well. For instance, electronic game consoles are not much use without games; computer operating systems are not much use without a suite of appli- cation programs; credit cards are not much use to cardholders without merchants that will accept them, and vice versa; and hydrogen cars are not much use without hydrogen filling stations, and vice versa. This important class of situations has highlighted the importance of cospecialization, and strategic decision making must now take this into account. The phenomenon is not new—the automobile industry depended first on the general store and then specialized retail outlets to make gasoline ubiquitously available to motorists. The role of complementary assets and cospecialization has already been recognized in the innovation process, and a decision framework outlined to chart the innovator on a course more likely to lead to a higher share of the available profit (Teece, 1986, 2007). What is new is that complements often sit on top of what might be thought of as ‘platforms,’ which are managed by an incumbent enterprise (Evans et al., 2006). In these circumstances, entry decision and ‘boundary’ conundrums exist. The platform owner needs complementary products to be provided by others, particularly when it has little or no relevant skills to develop them itself. Fostering innovation and entry by the providers of complementary products may, in fact, require the platform manager to commit (by word or deed) not to provide certain complements. When the inter- face between the complementors and the platform is itself evolving, decision rules become ever more complex. The platform owner and the complemen- tors might also need to consider whether the plat- form needs to be open or proprietary, and whether tools and other incentives should be provided to stimulate investment by the complementors. Deci- sion frameworks that recognize the importance of network effects, dispersion in the sources of innovation of complementary products, interoper- ability issues, and installed base trajectories must all be factored into decisions. Quality decisions will require uncommon foresight and the ability to shape outcomes. In this regard, the existing asset Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1333 is also essential. Management also needs to create an environment where the individuals involved in making the decision, at both the management and board level, feel free to offer their honest opinions, and look at objective (historical) data in order to escape from closed thinking. Incentives must also be designed to create neutrality when assessing investments in the old and the new. Considerable progress in combating biases has been made. Advisors call upon managers to adopt radical, nonformulaic strategies in order to over- come the inertias that inhibit breakthrough inno- vation (Davidow and Malone, 1992; Handy, 1990). Specifically, corrective strategies encourage change through two basic mechanisms: (1) design- ing organizational structures, incentives and rou- tines, to catalyze and reward creative action; and (2) developing routines to enable the continual shedding of established assets and routines that no longer yield value. Strategies that provide struc- tures, incentives, and processes to catalyze and reward creative action serve to attenuate problems of excessive risk aversion. For example, strategies that call on the enterprise to ‘cut overhead’ and ‘increase divisional authority’ can be interpreted as efforts to reduce the number of management lay- ers of the enterprise and to push decision making down to lower levels to minimize the inherent iso- lation errors associated with multilevel, hierarchi- cal decision-making processes. These recommen- dations can be viewed as organizational processes and strategic mechanisms to mitigate decision- making biases. Perhaps most importantly, executives must acknowledge the interaction effect between own- ing established assets and decision-making biases. Many recommended strategies (such as cannibal- izing profitable product lines and licensing your most advanced technology) call for the shed- ding of established capabilities, complementary assets and/or administrative routines to reduce the intensity of decision-making biases. By jettisoning ‘dead’ or dying assets, the enterprise is no longer shackled with an asset base that can be a crutch and provide a false sense of security, and sustain groups inside the enterprise that persist in torpedo- ing new initiatives. In abandoning dead or dying assets, the enterprise frees itself of certain routines, constraints, and opportunities for undesirable pro- tective action inside the enterprise. inspiration and help in Sources of the ‘anti-cannibalization’ bias men- tioned earlier can also be attacked. Self-serving Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj and other constituencies. Organizational identifi- cation (and commitment, which is the corollary) can dramatically augment enterprise performance, although it is doubtful it can override completely misaligned incentives. Nevertheless, group loy- alty is a ‘powerful altruistic force’ that conditions employee goals and the cognitive models they form of their situation (Simon, 1993: 160). Top management through its action and its commu- nication has a critical role to play in garnering loyalty and commitment and achieving adherence to innovation and efficiency as important goals. Since there is already an extensive literature on culture, commitment, and leadership, these issues are not discussed further. However, it would be a significant oversight in a summary statement of the dynamic capabilities framework to ignore them completely. Their full integration into the frame- work is left to others. However, it is recognized that to the extent such properties are not ubiq- uitously distributed amongst business enterprises, they can be a very important source of superior performance. Figure 2 summarizes the microfoun- dations identified in this section of the paper. MANAGING THREATS AND RECONFIGURATION Nature later The successful identification and calibration of technological and market opportunities, the judi- cious selection of technologies and product attri- butes, the design of business models, and the Selecting Enterprise Boundaries to Manage Complements and “Control” Platforms Calibrating Asset Specificity; Controlling Bottleneck Assets; Assessing Appropriability; Recognizing, Managing, and Capturing Cospecialization Economies. Enterprise Structures, Procedures, Designs and Incentives for Seizing Opportunities Building Loyalty and Commitment Demonstrating Leadership; Effectively Communicating; Recognizing Non-Economic Factors, Values, and Culture. Figure 2. Strategic decision skills/execution Strat. Mgmt. J., 28: 1319–1350 (2007) DOI: 10.1002/smj Dynamic Capabilities: Nature and Microfoundations 1335 As the enterprise grows, it has more assets to manage and to protect against malfeasance and mismanagement. Shirking, free riding, the strategic

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