1.2.1 Ordinary (and Superordinary) Capabilities

Ordinary capabilities, which encompass operations, administration, and governance of the firm’s activities, allow the firm to produce and sell a defined set of products and services. Ordinary capabilities are embedded in some combination of (1) skilled personnel, including, under certain circumstances, independent contractors; (2) facilities and equipment; (3) processes and routines, including any supporting technical manuals; and (4) the administrative coordination needed to get the job done.

A firm’s ordinary capabilities support technical efficiency (and hence productivity) in performing a fixed group of activities, regardless of how well- or ill-suited the outputs are to the market’s competitive needs (Teece, Reference Teece2007). Quality control methodologies, performance measurement, and payroll execution are examples of ordinary capabilities. The corresponding managerial modes include cost control and (static) optimization.

Ordinary capabilities can be measured against the requirements of specific tasks, such as labor productivity, inventory turns, and time to completion, and can thus be benchmarked internally or externally to industry best practices. The process of measuring and benchmarking increases the likelihood that the benchmarked capabilities can be bought or imitated by rivals using consultants and other available knowledge sources. Because of this imitability, good ordinary capabilities are generally insufficient to ensure a firm’s success and survival. While the diffusion of best practices is clearly neither instant nor complete, it takes only a few firms at the frontier to drive prices down to competitive levels, thereby dissipating any economic rents (profits above the level required to cover costs). The insufficiency of ordinary capabilities is most obvious after market demand shifts; there is no benefit to being very good at delivering products for which market demand has evaporated.

The development of excellence in performing a set of ordinary capabilities can actually lead a firm into complacency; a single-minded pursuit of efficiency and productivity can drive out the willingness to effectuate change when market conditions change. Henry Ford learned this the hard way a century ago. His Ford Motor Company used vertical integration to optimize the production process for the Model T. This worked well until the market shifted. Bringing a follow-on product, the Model A, to market was a long and arduous process that allowed General Motors (GM) to get ahead of Ford, a leadership position GM held for decades. As Benner and Tushman noted: “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, Reference Benner and Tushman2003, p. 242).

In certain cases, excellence in an organization’s ordinary capabilities can overcome the limitations of routines and become a source of prolonged advantage, particularly in sectors where technology is relatively stable. These “superordinary” capabilities are a form of “signature process” (Gratton and Ghoshal, Reference Gratton and Ghoshal2005), a valuable set of routines that have evolved in unique and nonobvious ways, which in turn makes them hard for others to imitate. Even signature processes will become imitable or beatable by others over time, but it could be a long time, even decades, depending on the levels of competition and market turbulence. The achievement of superordinary capabilities by some firms and not others helps to explain the wide dispersion of productivity within an industry among firms making more or less the same suite of products and services. However, even superordinary capabilities may become far less valuable after the market shifts, as seen during the transition from internal combustion engines to electric vehicles.

1.2.2 Dynamic Capabilities

Unlike ordinary capabilities, dynamic capabilities are hard for rivals to imitate or emulate because they rely more heavily on the entrepreneurial spirit, cognition, and attitude toward risk of the top management team. Under deep uncertainty (see Section 2.1.1), two organizations may receive the same set of market signals, yet draw opposite conclusions about, for instance, whether a new subscription model for an existing pay-as-you-go service would generate sufficient revenue to justify making the change.

Dynamic capabilities help enable an enterprise to profitably build and renew resources, reconfiguring them as needed to innovate and respond to (or bring about) changes in the market and in the business environment more generally (Pisano and Teece, Reference Teece2007; Teece, Pisano, and Shuen, Reference Teece, Pisano and Shuen1997). Strong dynamic capabilities allow the enterprise and its top management to develop conjectures about the evolution of consumer preferences, business problems, and technology; validate and fine-tune them; and then act on them by realigning assets and activities. Such capabilities are necessary and valuable when deep uncertainty is present, requiring managers to respond well to novel situations, such as a global pandemic, that may not have occurred for a long time, if ever. Firms also have lower-order dynamic capabilities. These are activities that entail the reconfiguration of resources but which the firm performs repeatedly so that there is a larger role for routines. These include activities such as acquisitions and new product development. Strong dynamic capabilities support innovation and high performance and rely on a change-oriented organizational culture and prescient assessments of the business environment and technological opportunities by the top management team.

Although, for discussion purposes, it is simplest to talk about dynamic capabilities as a collective object, it is important to bear in mind that they consist of many different activities, the roster of which will vary somewhat between firms. Each activity potentially demands managerial attention and, possibly, investment, to remain fine-tuned. In some business environments, such as those where technology is stable, where firms are heavily regulated, or where markets are closed to new entrants, the payoff from developing strong dynamic capabilities may not be high. In general, a given firm will be weaker in some dynamic capabilities than others for any number of reasons. However, weak dynamic capabilities will undermine the firm’s overall performance when operating in environments characterized by deep uncertainty and other sources of turbulence. To describe the contemporary business environment, it is not uncommon for businesspeople to refer to VUCA, a military acronym that stands for volatility, uncertainty, complexity, and ambiguity.

To bring some specificity to this subject, high-order dynamic capabilities can usefully be broken down into three primary clusters: (1) identification and assessment of threats, opportunities, and customer needs (sensing); (2) mobilization of resources to address fresh opportunities while capturing value from doing so (seizing); and (3) ongoing organizational renewal (transforming). These activities are required to create and sustain a firm’s competitive advantage. They need not be performed sequentially, often taking place in parallel on a more or less ongoing basis. Engagement in continuous or semi-continuous sensing, seizing, and transforming is essential if the firm is to sustain its performance as customers, competitors, and technologies change (Teece, Reference Teece2007).

While the decisions of individual managers and the top management team play a large role in a firm’s dynamic capabilities, the organization’s embedded values and culture as well as its collective ability and willingness to change are also integral (Teece, Reference Teece, Rosenberg and Hall2010b). The organizational aspects of dynamic capabilities are the product of past managerial decisions and current managerial leadership but that makes them slow to change, complex to understand, and difficult to imitate. Unlike ordinary capabilities, dynamic capabilities can’t easily be outsourced or acquired; they must often be “built” and maintained through investments of time and resources in discovery, knowledge generation, and learning. Sometimes, a small acquisition can create a beachhead upon which a larger organization can rapidly scale; recognizing the opportunity and effectuating it well requires strong dynamic capabilities.

Strong dynamic capabilities are necessary to determine whether the current slate of products and services will be the right path to follow in the future. Ordinary capabilities, by contrast, are valuable only during a given market window. It is only dynamic capabilities that can provide a firm the potential to sustain competitive advantage as the business environment changes.

2.1.1 Risk versus Uncertainty

Sensing capabilities are particularly important where the business environment is characterized by deep uncertainty – uncertainty which needs to be addressed differently from risk, with which it is often confused. With risk, the manager does not know what is going to happen but knows what the probability distribution of possible outcomes looks like. The model would be something like a short-range weather forecast. With deep uncertainty, however, we don’t know what is going to happen or what the possible distribution of outcomes (or futures) looks like. We don’t even know the range of possible outcomes. New storms never experienced before in a given geography may suddenly arise.

In a sense, business, like life, is always uncertain because unanticipated dangers can spring from anywhere. Technological uncertainty, which stems from many sources including the combinations of new components and new configurations of previously combined components, is a common feature across modern economies but is poorly understood. Most high technology industries are particularly prone to unforeseen innovations exiting stealth mode and causing a big shift in consumer demand. This is what happened with the introduction of the iPhone in 2007. Until then, few people seriously thought a handheld computer-phone was a good or practical idea. A few years later, the former leaders in the cell phone market, Nokia and RIM, were struggling to survive. This occurred not only because they failed to see how broadband networks would enable internet connections on the phone; it was also because they didn’t have the software capabilities that Apple could bring to bear (Teece, Reference Teece2023a).

Other aspects of the global business environment, including the political positions of whole countries, seem more subject to sudden, out-of-nowhere changes than was once the case. The fading of the US hegemonic role in a newly multipolar world is leading to much greater geopolitical uncertainty. And the interconnectedness of the global economy can propagate shockwaves from once-obscure corners of the globe to major markets in the turn of a news cycle.

The difference between risk and uncertainty was analyzed more than a century ago by economist Frank Knight. Knight (Reference Knight1921) explained that with uncertainty present, the primary problem for managers and investors is figuring out what to do. Execution (how to do it) is decidedly secondary. Uncertainty occasionally achieves public prominence. Nassim Taleb’s Reference Taleb2007 book about the financial industry titled The Black Swan (Taleb, Reference Taleb2007) was a salutary reminder that not every eventually can be accounted for.

Yet the strategic management of uncertainty in business is underdeveloped. The management of risk, which can be quantified in terms of probability, is widely taught, well understood, and widely practiced. But applying risk management tools like the point forecasts required of traditional capital budgeting can be “downright dangerous” and provide false comfort (Courtney, Kirkland, & Viguerie, Reference Courtney, Kirkland and Viguerie1997). Of course, a large unexpected shock can also turn out to be a potential positive, too. But that will also test an organization, as when a supplier suddenly receives a large order for a new component.

Unforeseeable external changes are what Nobel Laureate Tjalling Koopmans (Reference Koopmans1957) called primary uncertainty. Managers, especially in larger organizations, also face secondary uncertainty, which arises from a lack of communication across decision-making centers within an organization or across a network of firms. Internal sensing, such as opening lines of communication among divisions or partners, can reduce the prevalence of behavioral surprises that hinder execution.

Preparing for primary uncertainty is difficult because it basically requires a company to be ready for anything, able to absorb and rapidly respond to major upheavals. The goal should be to navigate unexpected events before problems reach crisis proportions. Organizational resilience and agility are not cost-free to develop, but, for firms in turbulent or unpredictable environments, they will pay dividends in a wide range of circumstances and may even spell the difference between survival and bankruptcy. The degree of flexibility must align with the firm’s (context-derived) strategy.

Flexibility is largely a matter of organizational culture, incentives, and leadership (Hitt, Keats, and DeMarie, Reference Hitt, Keats and DeMarie1998). To some extent, though, it can be obtained through investment choices. As Netflix CEO Reed Hastings observed, “at Netflix we almost always prefer to pay more for the option that gives us greater flexibility, knowing that we can’t – and shouldn’t – try to foresee what our business will look like down the road” (Hastings and Meyer, Reference Hastings and Meyer2020).

Strong dynamic capabilities aid in dealing with uncertainty through sensing and sensemaking exercises (Teece, Peteraf, and Leih, Reference Teece, Peteraf and Leih2016). Sensing under uncertainty is both more difficult and more vital than sensing when the environment is more certain. Logically, sensing under uncertainty may seem pointless since the uncertain is by definition unpredictable. However, as a social scientist once put it, “while we have to be prepared to be surprised by the future, we do not have to be dumbfounded” (Boulding, Reference Boulding1984).

2.1.2 Entrepreneurialism

Sensing capabilities are also closely associated with the idea of entrepreneurialism. To eighteenth-century thinkers such as Richard Cantillon, who is credited with the first use of “entrepreneur,” an entrepreneur was someone who put capital at risk to bring together factors of production needed to implement a money-making idea (Pesciarelli, Reference Pesciarelli1988). This captured one type of combination that entrepreneurs bring about, but it was perhaps not until Schumpeter (Reference Schumpeter1934) that the idea of “new combinations” of ideas, equipment, markets, and more was conceptualized as the essence of entrepreneurialism – and of economic growth.

There is of course more to entrepreneurialism than just recognizing promising new combinations. First, there is the process of sifting through the countless potential combinations that exist. Each must be calibrated in terms of the size of the addressable market, technological feasibility, and commercial viability in order to identify the best investment opportunity. Next, an organization must be built or reshaped to meet the requirements of the new activities. As new capabilities are developed and investments made, resources must be coordinated and kept in alignment.

These activities seem – and in fact are – very similar to the sensing, seizing, and transforming activities of the dynamic capabilities framework (Augier and Teece, Reference Augier and Teece2009; Teece, Reference Teece2012a). Entrepreneurial management, which also includes the leadership necessary to inspire and motivate an organization, is the heart of the organization’s dynamic capabilities (Schoemaker, Heaton, and Teece, Reference Schoemaker, Heaton and Teece2018; Teece, Reference Teece2016a). The more entrepreneurial and empowered the firm’s employees are, the better. Netflix CEO Reed Hastings described it as the difference between a classical orchestra and a jazz ensemble:

To some people, “entrepreneurial management” in large organizations may sound like a contradiction in terms. Entrepreneurship is typically conceived as a phenomenon for startup firms pursuing a new idea or business concept. Increasingly, however, large organizations are learning to respond to the rapid changes that digitization has brought in ways similar to startup firms, including the quick generation of software updates, rapid exploration of new product and service possibilities, and rapid abandonment of unsuccessful ideas. That is the very essence of dynamic capabilities, and it’s deeply embedded in the organizational DNA of almost all Silicon Valley firms – and of a growing number of firms worldwide.

Although the actions and pronouncements of the CEO are the most public representation of corporate entrepreneurship, entrepreneurial management in a dynamically capable organization extends deep into the management hierarchy. Middle managers must bridge between the visionary goals of top management and the chaotic realities of frontline workers in order for the vision to be realized. In this model, which Nonaka (Reference Nonaka1988) calls “middle-up-down management,” middle managers lead cross-functional teams to engage in the give-and-take of knowledge creation. The task of top management in this model is to motivate and to make strategic choices based on the output from a team or from rival teams (Song, Lee, and Khanna, Reference Song, Lee and Khanna2016). In this way, even major strategic shifts can originate at lower levels of management, as in the well documented example of Intel’s exit from memory chips in the 1980s to focus on microprocessors (Burgelman, Reference Burgelman1994). In short, strong dynamic capabilities require managers at all levels to have – and to be able to exercise – entrepreneurial skills.

2.1.3 Complementary Technologies

The entrepreneurial identification of potential new combinations, a key form of sensing, relies on the concept of complementarities. Complementarities are present whenever two or more items are more valuable in combination than in isolation – an idea in economics that dates back more than a century (Edgeworth, Reference Edgeworth1897). The complementarity can be reciprocal, like ham and eggs – both of which are potentially enjoyable in isolation. Or it can be unilateral, like video content and display devices – the content has limited value without a display outlet. Finally, the complements can be cospecialized, meaning that they are mutually necessary, like left and right shoes.

Within organizations, it is common for intangible assets, such as ways of doing business, to become so specialized to each other that they have little value if moved individually to a different organization through, for instance, a partial acquisition. Such assets can be thought of as “non-priced” because their value is so context dependent. It is, to a large extent, the custom, or “bespoke,” adaptations of particular tangible and intangible assets to one another that make the firm more than the sum of its parts – and different from a marketplace in which everything is priced according to supply and demand, especially in the digital economy (Teece, Reference Teece2018b).

This principle applies to innovation as well. The essence of innovation, in the Schumpeterian sense, is new combinations. This requires the detection (and creation) of not-yet-exploited complementarities. In 1836, US inventors patented the first practical combine harvester that both cut grain and threshed the edible portion from the straw in the field, replacing a separate reaper (invented in England in 1826) and a stationary threshing machine. This brought significant reductions in labor requirements and in grain waste. Almost a century later, in 1921, the US-based Atco company added an internal combustion engine to a mechanical mower (invented in England in 1830) and achieved immediate success.

Over time, through the contributions of multiple inventors, the complementary elements united to make a combine harvester were improved in ways that make them better suited to each other and to their joint purpose. In short, the identification (sensing) and effectuation (seizing)of promising new complementarities is an important part of a firm’s dynamic capabilities.

Technological complementarity occurs when the full benefit (or sometimes any benefit) of the innovation cannot be achieved until some other, complementary technology (which, on its own, has only lower value uses) has been created or re-engineered (Teece, Reference Teece1986). Thomas Edison, for example, didn’t invent the lightbulb and electrical generators in isolation; he conceived of them as part of a complete system that included improved generators and an electrical transmission network (Rosenberg, Reference Rosenberg1979). Likewise, the introduction of a new generation of cellular network requires new modem chips, wireless standards, and handsets that implement the technologies in order to enable value creation and capture.

Technological complementarity can pose a challenge for an innovator if the complement is created (or is owned) by a separate company and becomes a bottleneck asset (discussed below under Profiting from Innovation). One solution is to create the complement in-house; but the innovator may lack the capabilities to do so (Teece, Reference Teece1986, Reference Teece2006). That leaves either acquisition or partnership, depending on which is the most viable.

Technological complementarities are pervasive in the digital economy. Complicated products such as smartphones with many components and functions “read on” hundreds, if not thousands, of patents. Because of this multi-invention context, system-level innovation requires the in-licensing of patent portfolios to facilitate design and operating freedom (Grindley and Teece, Reference Grindley and Teece1997; Somaya and Teece, Reference Teece2006). This poses distinct strategic complexities because the sources of innovation have become more widely dispersed geographically as well as organizationally.

2.1.4 Absorptive Capacity

A particular perspective on complementarity is embedded in the concept of “absorptive capacity,” which was popularized by Cohen and Levinthal (Reference Cohen and Levinthal1990). It focuses on the potential complementarity of internal and external knowledge. More specifically, absorptive capacity includes the ability of a firm to identify useful external knowledge, combine it with existing internal knowledge, and commercialize the result. It thus bridges sensing and seizing, at least in the realm of technology, and has itself been analyzed as a type of dynamic capability (Zahra and George, Reference Zahra and George2002).

External knowledge can exist in many forms, and firms need very different processes to interact, for instance, with a university engaged in basic research, rival firms collaborating on standards development, or suppliers involved in late-stage development work (Lim, Reference Lim2009). A key unifying idea, however, is that the ability to benefit from any type of knowledge stream depends on the firm’s prior internal knowledge and ability to learn (Cohen and Levinthal, Reference Cohen and Levinthal1989; Lane and Lubatkin, Reference Lane and Lubatkin1998). Thus, like other capabilities, the strength and value of a firm’s absorptive capacity depend on the quality of the underlying processes and the appropriateness of the mental models used by the firm’s top management and researchers.

2.1.5 General Systems Theory

To move from sensing to sensemaking, managers must adopt a big-picture perspective on the organization, its capabilities, and its environment. This calls for a system-level perspective, something which academic fields – and too many C-suite executives – fail to adopt.

The idea that the whole is more than the sum of its parts dates back to at least Aristotle’s Metaphysics from the fourth century BC. In other words, a useful understanding of a complex system can’t be obtained simply by examining its parts any more than a tail, fur, claws and whiskers could be assembled into a living cat. Understanding each of the parts is important but understanding their integration and interactions is critical because they determine the endogenous changes through which the system evolves. A holistic view is valuable at the team level, too. One of the founders of systems theory, Kenneth Boulding, noted that “one of the main objectives of General Systems Theory [is] to develop … a framework of general theory to enable one specialist to catch relevant communications from others” (Reference Boulding1956, p. 199).

In the case of an open system such as a corporation, general systems theory also encompasses the system’s interactions with its environment. Feedback loops between the outside and the inside of the firm lead to the internal adjustments that enable adaptation to external changes while potentially shifting the external environment as well.

The development of a general theory of systems emerged in the twentieth century from separate research in various disciplines including biology, cybernetics, and economics. Economist/social scientist Kenneth Boulding made the case for a systems theory approach to management (Boulding, Reference Boulding1956). Systems theory became a popular approach in the 1960s and 1970s but failed to make much headway, perhaps because its early promoters, such as Boulding and C. West Churchman, failed to make it operational.

However, a systems approach to management survives in the form of a widely used congruence theory of organizational alignment by Nadler and Tushman (Reference Nadler and Tushman1980). It is still invoked at times by academics who want to emphasize the integrated nature of the elements in a model.

Systems-based approaches are difficult to implement because they are inherently cross-disciplinary, and business education currently fails to do a good job of integrating the elements of the curriculum. Academics and practitioners master fields such as accounting, marketing, operations, manufacturing, and data analytics. However, they are often unable to discuss them as integrated and interrelated activities. Yet a partial understanding of a system can impose intellectual blinders. And failure is all but guaranteed when elements of a system are mismatched. As Russell Ackoff once observed:

A business model, for example, involves a product or service, a pricing logic, a geography of distribution, and so on (Teece, Reference Teece2010a). These elements may or may not be chosen or developed separately from each other. However they are brought into play, the elements of the model must be coherently aligned and linked to an astute strategic vision if they are to lead to profits. If an element doesn’t fit properly, for example, if productive capabilities are inadequate to reach the expected product quality and/or volume, then the model will not perform as desired.

One area where there has been at least a modest amount of systems thinking is digital platforms. The concept of indirect network effects (Clements, Reference Clements2004) recognizes that a platform or service depends on two or more user groups (e.g., producers and consumers, or users and developers). As more people from one group join the platform, the platform’s value to the other group increases. Companies such as Uber, Grubhub, or Facebook all rely on these indirect effects. It’s not that more drivers make Uber or Lyft more valuable to other drivers (a direct effect); it’s that more drivers make the service more valuable to passengers.

The study of platform business models has given rise to a recognition of the importance of business ecosystems (Jacobides, Reference Jacobides2019; Teece, Reference Teece2012b, Reference Teece, Augier and Teece2016b). In ecosystems, the focus of value creation is as much outside the enterprise as within. Orchestrating relationships laterally and vertically with interdependent players requires not only strong sensing, seizing, and transforming capabilities but also a system-level perspective. The platform leader must balance its own interests with those of a plethora of actors who do not always have the same priorities, even if all of the firms share the goal of leveraging the platform.

Whereas general systems theory doesn’t provide a toolkit for deciding which relationships in a digital platform or ecosystem are most critical at a particular point in time, dynamic capabilities offers guidance through its incorporation of theories such as Profiting From Innovation (discussed later). The dynamic capabilities framework (see Figure 2) is thus a workable version of systems theory for application to strategic management (Teece, Reference Teece2018a), including the leadership of digital platforms and ecosystems. And, like systems theory, the dynamic capabilities approach requires interdisciplinary, ecosystem-level understanding. It demands that top managers have deep insights about many aspects of an organization and its business environment.

Many great managers follow the precepts of the dynamic capabilities framework intuitively without having the terminology to be more explicit about it. They make a change only after serious forethought about how it will play out across the organization and for all stakeholders. By making the elements and interrelationships of great management more explicit, dynamic capabilities can galvanize managers and management to allow the achievement of better results.

Figure 2 The key elements of the dynamic capabilities framework.

Note: A dashed border indicates elements that are external to the firm. Arrows represent major interdependencies associated with the business enterprise. Markets and customers are left out; the focus here is on what economists call the supply side.

Source: Based on Teece (Reference Teece2018a)

2.1.6 Complexity Economics

Complexity theory is the study of a particular type of system: a nonlinear dynamic system with feedback mechanisms. Complexity theory is a relatively young discipline that has increasingly been applied to business phenomena (Levy, Reference Levy, Rabin, Miller and Hildreth2000). It fills the gap between the broad focus of systems theory (discussed in Section 2.1.5) and the regenerative disequilibrium of inter-firm competition. For this reason, it began to attract the attention of management scholars in the 1990s.

Complex systems combine elements of systems theory with chaos theory (Schneider and Somers, Reference Schneider and Somers2006). Chaotic effects include unforeseen emergent properties and a tendency for small changes in key parameters to generate large changes in results. These contingent effects are in keeping with the dynamic capabilities framework’s emphasis on unique, path-dependent outcomes. For example, the dynamic capabilities framework emphasizes the importance of managing complementarities among assets. In complexity terms, the combination of complementary assets can lead to the emergence of innovation not discernible from characteristics of the complements in isolation. At a higher level, the combination of the complementary sensing, seizing, and transforming activities of dynamic capabilities can lead to the emergence of superior enterprise performance (Kay, Leih, and Teece, Reference Kay, Leih and Teece2018).

This is not to say that these systems are somehow predetermined. On the contrary, a theory of complex systems points to the need to develop organizational flexibility and resilience (Levy, Reference Levy1994). The fundamental challenge is to find a balance between too much structure and too little, and to keep that balance aligned with the turbulence of the environment, raising the likelihood that a business can change when it needs to (Eisenhardt and Piezunka, Reference Eisenhardt, Piezunka, Allen, Maguire and McKelvey2011). In a study of firms in the turbulent computer industry of the 1990s, for example, Brown and Eisenhardt (Reference Brown and Eisenhardt1997) found that those which were most successful at innovation possessed only limited structure. This allowed for improvisation and decentralized decision making. Leaders constantly explored future scenarios to determine what new products might be needed next.

Although complexity theory is sometimes used to build formal models and generate simulations (e.g., North and Macal, Reference North and Macal2007), the practical value of this approach is limited by the fact that, in organizations, unlike physical systems, individuals can make unpredictable changes to the “parameters” of the situation. The future, beyond a narrow window, is unknowable, and dramatic change can occur suddenly. The way forward for business enterprises, big and small, is not just to be adaptable but also to endeavor to shape the environment either through new technology or through “partnering” with regulators and governments.

The economic study of the business environment, including the behavior of consumers, investors, businesses, other populations, and institutions, is known as complexity economics. As a field, complexity economics has struggled to find its footing. It got some traction at the Santa Fe Institute, a nonprofit think tank, beginning in the late 1980s.

Complexity economics abandons the usual economic assumptions of rational actors, commonality of knowledge, and equilibrium outcomes. Instead, it views the economy as built up from individual behaviors, which react to the economy and, in turn, shape that economy, leading to new behaviors and so on, in a complex, recursive loop (Arthur, Reference Arthur2021).

Arthur’s perspective is very consistent with the dynamic capabilities framework. However, where complexity economics takes a wide-angle view and is often quite general, the dynamic capabilities approach is primarily applied at the organization level and is strongly prescriptive.

2.2.1 Creative Destruction

While disruptive innovation gets a great deal of attention, not all innovation disrupts. Innovation by a complementor (e.g., better apps in an app store), for instance, can enhance the relevance of an incumbent platform. And even potentially disruptive innovation can play to the strengths of an incumbent firm. In other words, while some innovations are “competence destroying” for incumbents, other innovations are “competence enhancing” (Tushman and Anderson, Reference Tushman and Anderson1986). In an example from the mid-twentieth century, the introduction of electric typewriters represented a product update that manual typewriter incumbents could potentially match while building on their existing capabilities, as Smith-Corona and Remington did in response to the success of electric models from IBM.

Competence-destroying innovation, on the other hand, opens wider capability gaps for incumbents, requiring strong dynamic capabilities to fill them. In practice, many incumbents fail to rise to the challenge due to inertia. The electronic calculator made slide rules obsolete, and digital photography has all but eliminated the once-huge emulsion film business. Even competency-enhancing challenges can overwhelm weak incumbents. The Underwood typewriter company eschewed innovation and moved too late to acquire the necessary technology to electrify, eventually being acquired by a European company that was (unsuccessfully) targeting the US market (Golder, Reference Golder2000).

Complex, systemic innovations (Teece, Reference Teece1984) may encompass both kinds of innovation. The innovations in electric vehicles are a combination of competence-enhancing and competence-destroying technologies with respect to auto industry incumbents. The complex internal combustion engine, with its many moving parts, is completely eliminated, but road-holding capabilities, crashworthiness, and passenger comfort technologies aren’t changed nearly as much.

The cycles of change in which innovations are introduced into the market by new or existing firms and displace incumbent leaders is known as creative destruction. This goes on all the time and drives competition and productivity. It’s the engine of change and progress.

Joseph Schumpeter (Reference Schumpeter1942), an economist, popularized the concept of creative destruction in business and economics in the mid-twentieth century. But almost a century before him, Karl Marx had explained how capitalism was reliant on this process. The Communist Manifesto, for example, notes: “The bourgeoisie cannot exist without constantly revolutionising the instruments of production” (Marx and Engels, Reference Marx and Engels1848/1906, p. 17).

Nevertheless, the idea was still radical when Schumpeter wrote about it. The economics discipline of his time included no provision for innovation, entrepreneurship, or technology, and it relied on models that tended toward a steady-state equilibrium. In sharp contrast, Schumpeter held that entrepreneurs and new technologies create disequilibrium, which leads to new profit opportunities. Looked at another way, Schumpeter placed innovation at the heart of economic growth. Although today innovation is often conceived of in terms of disruption and revolutionary change, Schumpeter viewed innovation as analogous to biological mutation, and creative destruction as an “evolutionary process” (Schumpeter, Reference Schumpeter1942, p. 82). The dynamic capabilities framework can guide companies as their managers choose in which area to innovate and how to best prepare the enterprise to do so, including restructuring (transformation) if. A related, capabilities-based framework in the antitrust field is called “dynamic competition” (Teece, Reference Teece2023b). It is a broader concept than creative destruction because it recognizes that (nondestructive) competency-enhancing innovation can also be a driver of competition. A truly innovation-driven economy can drive waves of growth. “Innovation drives competition, and competition in turn drives innovation” (Sidak and Teece, Reference Sidak and Teece2009).

2.2.2 Profiting from Innovation

Managers in an innovating firm need to embed innovations in a sustainable business model that can support future innovation. This effort implicates issues of intellectual property and appropriability that can be addressed with carefully designed market entry strategies (seizing). Notably, innovators do not always profit the most from their innovation. Sometimes a fast second entrant – or even a slow third – will imitate or emulate the innovator and be able to capture most of the market. Apple’s iPod was not the first standalone MP3 player, but it dominated the category for more than a decade (Cole, Reference Cole2013). Merck was a pioneer in cholesterol-lowering drugs (Zocor), but Pfizer, a late entrant, secured a superior market position with Lipitor (Hilzenrath, Reference Hilzenrath1998). In other cases, pioneers such as Genentech (biotechnology), Intel (microprocessors), and Dell (computer distribution) prospered for decades.

A model that helps to explain why some innovators thrive and others vanish was developed by Teece (Reference Teece1986, Reference Teece2006, Reference Teece, Augier and Teece2018c; Winter, Reference Winter2006). This research has spawned a body of work that has come to be known as the profiting from innovation (PFI) model, or simply “the Teece model.”Footnote ³

Key concepts in the model are complementarities and appropriability, the extent to which the innovator can capture the profits generated by the innovation. The degree of capture is influenced by the interaction of the technology and the legal environment. Appropriability can be strong when innovations are easy to protect because knowledge about them is tacit and/or they are well protected legally. Appropriability is weak when innovations are difficult to protect, as when they can be easily imitated and/or legal protection for the relevant type of intellectual property is ineffective. For example, Laker Airways’ pioneering low-price, “no frills” transatlantic service was launched to rapid success in 1977, but rivals Pan Am, TWA, and British Airways dropped their prices starting in late 1981 and the fragmented demand was insufficient to keep the thinly financed Laker in business.Footnote ⁴

Although strategy must be set based on the appropriability regime in place at the time, appropriability regimes can change. Moreover, the regulatory regime applicable to a given innovation can be influenced by firms (Pisano and Teece, Reference Teece2007). Put differently, dynamic capabilities is not only about adapting to the business environment but also about shaping it. This is one of several ways that dynamic capabilities framework goes far beyond the literature on adaptive organizations.

The essence of the PFI theory, though, is that few innovations can become profitable in isolation. Almost all innovations require the use of complementary assets and technologies (Teece, Reference Teece2006), which in turn require investment. The strength of legal protection on the innovation, the ease of imitation, and the types of complements required can account for how the value generated from the innovation is distributed among the innovator, rivals, complementors, suppliers and consumers. The theory of PFI posits that profits in a business ecosystem tend to migrate to the “bottleneck” asset – that is, the asset that is needed and is hardest to replicate. This could be the innovation itself, but more often than not it also includes a complementary asset that may or may not be owned or controlled by the pioneer.

The list of critical complements includes complementary technologies and capabilities such as marketing, manufacturing, after-sale service, distribution, and software. It also includes intangible assets, such as a viable business model, customer relationships, reputations, and organizational culture. If an innovator is slow to realize the importance of complements, does not have them or cannot easily access them, it is likely to lose out to an imitator that is strong in these areas. British company EMI’s CAT scanner, for example, was a sophisticated machine that required a high level of customer training, support and servicing. EMI had none of these capabilities, could not easily contract for them and was slow to realize its strategic vulnerability (Teece, Reference Teece1986, p. 298). Competitors like GE with more experience selling complex healthcare equipment (along with the important complements of an experienced sales and marketing organization and a good reputation) were able to work around EMI’s intellectual property and get into the market quickly with improved versions.

A corollary of the need to identify valuable complements is that non-strategic complements can usually be outsourced, provided they’re supplied in the market at competitive rates. SpaceX, which has unique requirements for its pioneering vision of reusable rockets, makes most of its inputs, from rocket engines to electronics components, in-house.

Over time, though, the capabilities of the supply base can evolve. Qualcomm, for example, manufactured (through a joint venture with Sony) the mobile phones that used its proprietary CDMA chips starting in 1994 because there were no firms familiar with designing such phones. By 1999, the CDMA handset market had become sufficiently mature that Qualcomm was able to end its own manufacturing.

The points where the insource/outsource boundary should be drawn is not always clear (Chesbrough and Teece, Reference Chesbrough and Teece1996). The PFI model can help by identifying the strategic issues, but in the end it’s a judgment call. Consider fabrication in the semiconductor industry. Beginning in the 1970s, AMD competed fiercely with Intel in the microprocessor market. By the 2000s, chip fabrication had become highly capital-intensive yet also increasingly available as a service. In 2008, AMD spun out its manufacturing into a joint venture with which it took a long-term supply agreement while also starting to source its processors from an established manufacturing services provider called TSMC. Intel appeared to have made the better choice and gained market share until it stumbled after 2015 while ramping up its next generation of manufacturing. Since then, it lost all of what it had gained against AMD.Footnote ⁵

PFI theory provides decision criteria that are a critical part of a firm’s “seizing” capability. It informs the design of the innovator’s business model choice about whether to supply a complementary component or activity in-house or to contract for it (Jacobides, Knudsen, and Augier, Reference Jacobides, Knudsen and Augier2006). Making this decision correctly is one of the most critical steps for securing the innovator’s profitability/competitive advantage (Teece, Reference Teece2010a). It requires that the innovator correctly assesses the firm’s existing capabilities and/or its ability to develop new ones related to the complement in a timely, cost-effective manner.

2.2.3 Resource-Based View

Bottleneck assets, which command a profitable position, are at the heart of another theory of competitive advantage, known as the resource-based view (RBV) of the firm. It was developed in the 1980s by management scholars building on the earlier work of economists like Edith Penrose (Reference Penrose1959) and Paul Rubin (Reference Rubin1973). It is one of the foundations of the dynamic capabilities framework and stimulated its development, partly as a reaction to deficiencies of the RBV.

Resources are the tangible and intangible assets, broadly defined, that the firm can effectively control. These include not just physical assets, like pieces of equipment, but also abstract assets that are owned, like patents, or at least “rented,” like the skills of the firm’s employees.

Penrose (Reference Penrose1959) had theorized that a firm at any point in time is likely to have underutilized resources, which creates the potential to steer their excess capacity into new lines of business to generate growth. Decades later, scholars, including Teece (Reference Teece1982), Rumelt (Reference Rumelt and Lamb1984), and Wernerfelt (Reference Wernerfelt1984), picked up on the idea of resources, theorizing that a firm’s control of unique resources can be a source of economies of scope and, possibly, sustainable advantage. This was further developed and popularized by Barney (Reference Barney1991) with the acronym VRIN because the resources most important to control are those that are valuable, rare, inimitable, and nonsubstitutable.

Yet, these cannot be the whole story behind competitive advantage, because what makes a resource valuable is how it is used. Also, what’s valuable today may not be valuable tomorrow, and a good theory of competitive advantage must address these evolutionary considerations.

More fundamentally, though, it is the capability of managers to coordinate the firm’s resources and channel their use into profitable activities that gives the resources their value (Spender, Reference Spender1994). Others note that the term “resource” is rather vague, encompassing all manner of assets/inputs and capabilities/knowledge (Kraaijenbrink, Spender, and Groen, Reference Kraaijenbrink, Spender and Groen2010).

Moreover, the RBV is essentially a static theory. In reality, VRIN attributes are very context-dependent, and contexts change. Resources that are rare and valuable can be undermined by new developments. Blockbuster’s nationwide retail footprint became a liability when Netflix’s mail-based rental system became popular. A patent may be inimitable, but it can also expire or be invented around.

A deeper issue is that the RBV offered little or no explanation or framework for deciding how a firm should develop or acquire new resources and then manage them over time. The long-term viability of a firm requires not just the amassing of key resources but also a continuous learning process, periodic pruning and augmentation, and ongoing orchestration of intangible assets and other resources. The strategic management of resources is at least as important as their mere possession. The dynamic capabilities framework accepts the VRIN criteria but is built around how VRIN resources arise in the first place and are continuously renewed. The weakness or lack of the capability to renew a firm’s resources will hamper the long-run sustainability of its profits. In essence, the dynamic capabilities framework puts the resource-based view on wheels.

2.2.4 Growth-Share Matrix

A top-down approach to seizing can be found in the growth-share matrix, popularized by the Boston Consulting Group. It considers only the firm’s product lines and their respective prospects. The core idea is that it is best to invest in a growing business with a healthy market share.

The growth-share matrix is a popular guide to this kind of reallocation. A matrix that crosses growth with market share was developed in the 1960s and popularized by the Boston Consulting Group through an article that appeared in a company publication (Henderson, Reference Henderson1970). It found increasing use during the 1970s as the conglomerate form of corporate governance became more common. The conglomerate mindset, like the growth-share matrix, views the firm as a portfolio of strategic business units to be managed like assets that can be bought and sold.

Using a 2-by-2 grid, shown in Figure 3, business units are mapped in terms of market growth and relative market share. On the vertical axis is market growth rate, and on the horizontal axis is the firm’s relative market share. The four quadrants are classified as “dogs” (low growth, low share), “cash cows” (high share but low growth), “stars” (high growth, high share), or “question marks” (high growth but low share).

Figure 3 Growth-share matrix

The matrix rests on two ideas: the “product lifecycle curve” and the “learning curve” – reasonable assumptions in many manufacturing and service businesses (Geissler and Krys, Reference Geissler, Krys, Schwenker and Wulf2013). The product life-cycle curve captures the idea that products go through different stages from launch to decline, with different cash requirements at each stage. The largest cash requirements occur during a high growth phase, when firms are trying to capture the greatest market share before the industry settles down. The learning curve expresses the relationship between experience and efficiency: the more often a task is performed, the lower the cost of doing it. The implication is that the lowest cost producer will both capture a larger share and earn a larger profit per unit.

With this in mind, the quadrants of the matrix can be seen as revealing the cash flow of a business today and its prospects for the future. Businesses in the early stage of their lifecycle are likely to experience a negative net cash flow as the firm invests to grow and pursue market share. As a successful business matures, it should be delivering steady profits commensurate with its market share. The emphasis on cash flow is particularly relevant when the economy constrains access to capital markets, as occurred during the stagflation of the 1970s (Davis, Reference Davis, Augier and Teece2016).

The most desirable type of business unit (“Star”) is one experiencing high growth in which the firm has a large relative market share. It could be a maturing business in which the focal firm has helped drive rapid uptake. Businesses in this quadrant warrant significant investment to reap the benefits of continued growth. The worst (“Dog”) has both low growth and low share. This may be a product line that is past its high-growth phase or that never really took off and where the focal firm has been outcompeted. The logic of the matrix is that a “dog” business should be divested or drastically rethought.

Businesses that aren’t growing much but where the focal firm has a relatively large market share (assumed to translate to a cost advantage) are deemed “Cash Cows.” Investment needs to be maintained but these businesses should mainly be treated as a source of cash to reinvest elsewhere. The opposite situation is a business with high growth but where the firm is a small player. This “Question Mark” could be either a growth opportunity or just a missed one. Depending on the particulars of management’s intuition, internal resources, and the business climate, businesses in this quadrant may warrant further investment or they may be best divested.

The key insight is that the right time to invest heavily is in the growth phase of an industry. If significant market share fails to be won, then there’s little point pouring in more funds as the industry’s growth slows. This makes intuitive sense for large shifts between industries, but it may apply to frequent, smaller shifts as well.

Active reallocation of free cash flow across segments is one way to achieve the (dynamic capabilities) goal of semi-continuous transformation. A study by Lovallo et al. (Reference Lovallo, Brown, Teece and Bardolet2020) found an inverted-U relationship between the extent to which firms changed their investment pattern among business segments and the amount by which their return on assets exceeded the industry average. Most firms in their sample of multi-segment firms with annual sales greater than $50 million were located on the left (upward) side of the curve; that is, they would still have likely benefited from additional shifts in their allocation pattern. The same U-shaped pattern was found in a 2023 survey of more than 2,000 CEOs by professional services firm PwC; 86 percent of the firms in the survey reallocated less than 30 percent of their financial and human capital year to year and could potentially have increased their profit margins by doing more (PwC, 2024).

One problem with the matrix is that it assumes predictability, which is a risky assumption in a global economy riven by deep uncertainty. What looks like a growth industry today can stall or crash in the next period. A capabilities approach would use other criteria, supporting investment in business lines that rely on existing proprietary capabilities and sound business models. Market share is not a great metric because it reflects the past, not the future.

Corporate coherence – the relatedness of a company’s capabilities – is another important dimension that the growth-share matrix fails to capture (Teece et al., Reference Teece, Rumelt, Dosi and Winter1994). Growth and market share matter, but so do the interdependencies of the firm’s capabilities. Business units may interact technologically, or they may share common resources that would be too costly to maintain if one of the businesses – even a “dog” – were divested. A high-growth business that bears little relation to the firm’s other activities may prove less valuable in the long run than a slightly less successful business that leverages or enhances existing capabilities. Maintaining coherence today will help growth tomorrow.

By the same token, businesses in the “Dog” quadrant could be good transformation candidates if they’re a good fit. The decision to invest depends on how good management is at transforming businesses and developing fresh business models and strategies.

Companies should also invest speculatively in businesses and capabilities that are expected to be valuable in the near future and divest businesses that bear little relation to the company’s capability base. The dynamic capabilities approach is generally unsympathetic to the conglomerate form of corporation, which is based on the capability-neutral notion that a good manager can manage any kind of business. True conglomerates have become increasingly rare in the major economies, although they can still be found in some industrializing nations where the market for corporate control is less well developed (Linden and Teece, Reference Linden, Teece, Augier and Teece2018).

The predictable world of the growth-share matrix makes sense to the extent that it’s a short-term (typically five-year) perspective on the company. The dynamic capabilities approach favors longer-term strategizing where the prospects of any given business are much less certain.

2.2.5 Simple Rules

Part of the appeal of the growth-share matrix or any similar “rule of thumb” management tool over more complex frameworks such as dynamic capabilities is that they yield straightforward rules to guide key decisions. Kathy Eisenhardt and her coauthors extended this preference to develop a theory of simple rules as a basis for strategy. As mentioned earlier, Eisenhardt had included (a limited, routine-based version of) dynamic capabilities as an example of the “simple rules” she posited as a substitute for formal strategy-making in fast-moving or uncertain markets (Eisenhardt and Martin, Reference Eisenhardt and Martin2000; Eisenhardt and Sull, Reference Eisenhardt and Sull2001). Simple rules, or heuristics, may cover how things are done, what things are most worth doing, when to do them, and what things not to do. An example for a large firm might be “any business line that grows larger than $1 billion must be split in two.” These rules are meant to change over time, especially if they no longer seem to be working. Nor should there be too many of them. Eisenhardt and Sull (Reference Eisenhardt and Sull2001, p. 113) suggest a maximum of seven.

Eisenhardt and Sull (Reference Eisenhardt and Sull2001) contrast simple rules with two traditional views of strategy: resource accumulation (e.g., the resource-based view) and establishing and defending a position (e.g., Five Forces, which is discussed in the companion Element, Dynamic Capabilities and Related Paradigms). Resource and positioning strategies are one-shot models, with no guidance for sustaining competitive advantage when circumstances shift. Viewed in that way, simple rules can serve as dynamic guides for faster decisions in complex environments, avoiding analysis paralysis.

Like organizational capabilities, simple rules grow out of experience, which suggests some path dependence (and potential core rigidities). Yet Eisenhardt and Sull simply refer to firms moving fluidly from old rules to new rules when circumstances change. The managerial processes or cognition that enable this flexibility – recognizing a misalignment and identifying a solution – go unaddressed. Sull and Eisenhardt (Reference Sull and Eisenhardt2012) describe how rules can evolve based on analysis of the associated outcomes. But, when it comes to dropping a key rule, no insight is offered about what must surely have been a managerial decision.

Bingham and Eisenhardt (Reference Bingham and Eisenhardt2011) filled this gap by describing a higher dynamic capability governing the addition and subtraction of the simple rules (which guide the processes they previously identified as dynamic capabilities). They call this dynamic capability simplification cycling. In one direction, firms add to the number and complexity of simple rules that they follow. In the other direction, they replace some rules and drop others entirely. In terms of the tripartite nomenclature used in this Element, simplification cycling is part of the firm’s seizing activities, the means by which it pursues opportunities or other goals.

A logical implication of the addition and subtraction of rules in response to shifts in the firm’s fit with the environment is that managers exercise discretion. However, Eisenhardt and colleagues seem uninterested in exploring this ability to exercise personal judgment. Instead, this stream of literature treats intuitive, entrepreneurial decision making as “improvisation” (Bingham, Reference Bingham2009).

Eisenhardt and her colleagues provide evidence that simple rules play an important role in organizational capabilities, particularly those mid-level capabilities I call microfoundations, such as internationalization and alliance formation (Bingham, Eisenhardt, and Furr, Reference Bingham, Eisenhardt and Furr2007). In the dynamic capabilities framework, however, it is the ability of top management to make idiosyncratic decisions as the situation requires that gives the firm flexibility and uniqueness (Kay, Leih, and Teece, Reference Kay, Leih and Teece2018).

2.2.6 OODA Loops

An alternative approach to managing in fast-moving environments originated in the 1970s with a retired Air Force officer and instructor named Colonel John Boyd: the OODA Loop. The OODA Loop, a model of agile decision-making, has four components: Observe, Orient, Decide, and Act (Figure 4). These are often treated as purely sequential, but Boyd imagined short-loop feedback in the system as well (Rule, Reference Rule2013).

Figure 4 Diagram of an OODA Loop

“Observe” takes in signals from the external environment. “Orient” is a frame of reference or mental map of the decision space that is influenced by the decision maker’s own culture, personality, and experience. “Decide” is the individual’s choice based on observations conditional on orientation. “Act” then influences the external environment, leading to a new decision cycle based on the updated situation. These will unfold in real time, whether on the battlefield or in the boardroom, repeating as the situation requires. Boyd emphasized the need for continuous interaction with the external environment in order to keep mental maps updated (Watts and Augier, Reference Watts and Augier2022).

There is a loose analogy between the OODA Loop and dynamic capabilities. Observation and orientation are akin to sensing and sensemaking. Deciding and acting are similar to seizing and transforming.

There are key differences as well. The OODA process, for instance, is aimed at gaining short-term wins in the course of a conflict, as opposed to longer-term competitive advantage. More importantly, the need to observe before taking action limits its applicability in situations where (unobservable) unknowns play a significant role.

Dynamic capabilities, moreover, are organizational, whereas OODA loops are conceptualized at the individual level. To implement strategy at a high level, an organization needs the agility afforded by strong dynamic capabilities as well as the tactical flexibility enabled by OODA loops. Lou Gerstner, who was a transformative CEO at IBM, observed at the start of his tenure that “you have to be fast on your feet and adaptive or else a strategy is useless” (Sellers and Kirkpatrick, Reference Sellers and Kirkpatrick1993).

2.3.1 Transaction Costs

As we saw in the PFI model, a key question when seizing an opportunity is which activities to conduct in-house versus through outsourcing. A leading economic theory advanced to explain and guide these decisions is that firms organize their activities to minimize their transactions costs. Transaction cost theory can be traced back to a 1937 article by future Nobel laureate economist Ronald Coase (Reference Coase1937). Nearly forty years later this was developed into a research domain known as transaction costs economics (TCE) by another future Nobel laureate, Oliver Williamson (Reference Williamson1975, Reference Williamson1985a).

A core insight in TCE is that external (contract- or market-based) activities benefit from the discipline of price, but they have an inherent weakness due to the difficulty of writing and enforcing contracts that truly cover all possible contingencies. Contractual incompleteness can sometimes allow opportunistic recontracting. Meanwhile, in-house activities offer the attractive feature of total control under all circumstances, but they are subject to the inefficiencies of bureaucratic management. Firms seek to balance the costs and benefits of each mode of governance as they choose whether a particular activity should be owned or contracted. Williamson also considered intermediate forms of organization such as strategic alliances and long-term supply relationships.

The main consideration in TCE for assessing the vulnerabilities of contract-based relationships is “asset specificity,” the extent to which assets are tied to a particular relationship. When a non-redeployable investment is to be made by one party to a contract, a “fundamental transformation” occurs. Williamson (Reference Williamson1985a) warned that large-numbers bargaining with, for example, a number of potential suppliers can collapse to one or none once any dedicated, non-redeployable investments have been made. The collapse leads to “small-numbers bargaining.” In Williamson’s view, because of exposure due to the inherent incompleteness of contracts, the firm that made a relationship-specific investment can become hostage to its partner, leading to the possibility of opportunistic renegotiation over the distribution of economic “rents” (profits). Because the potential risk is known in advance, the most economically efficient mode of organization for the activity would be to bring it in-house. The fear of opportunism and the migration (once transaction-specific investments are made) to strategic dependence loom large in TCE. The process whereby a competitive playing field can collapse to a small-numbers market is what Williamson called “the fundamental transformation” (Williamson, Reference Williamson1985a, Reference Williamson1985b). This occurs because transaction-specific investments reduce the set of available alternatives (e.g., suppliers) from a large number (the ex ante bargaining situation) to a limited choice (possibly only the one firm that made the investment).

Others have pointed out that an investment required to fulfil a contract may also deter the entry of other firms (e.g., rival suppliers), providing security that offsets the risk of becoming a hostage (Nicita and Vatiero, Reference Nicita and Vatiero2014). In practice, complex supply agreements that involve investments dedicated to a supply relationship take place all the time (De Figueiredo and Teece, Reference De Figueiredo and Teece1996), as the chaos affecting global supply chains in the wake of Covid-19 lockdowns revealed.

Opportunism, as stressed by TCE, exists and ought to be – and can be – guarded against. However, the dynamic capabilities approach emphasizes building (through investment and through learning) the unique specialized resources that TCE implicitly assumes are already available for possible contracting. Dynamic capabilities also entail keeping the organization aligned with its business environment, which may require transformations such as moving activities across the in-house/contracted threshold, even though the relevant transaction costs haven’t changed. It might be necessary, for example, to internalize a previously outsourced activity in order to improve the feedback across the value chain as a next-generation product is developed.

The choice of whether to position an activity inside or outside the boundary of the firm is a critical decision when seizing new opportunities. Transaction cost economics addressed a deficiency in the standard production-oriented view of the firm, which treated in-house and contracted activities interchangeably. However, as with many developments in business and economics research, it did this so narrowly that it committed the reciprocal error of holding production costs equivalent across the two options (in-house and contracted).

TCE ignores the value of integrating diverse pools of technology and know-how inside firms to facilitate knowledge sharing. A narrow focus on transaction cost issues could lead to a recommendation for outsourcing an activity that has learning and knowledge linkages to other internal operations, potentially undermining future capability development. Narrowly focused economic theories can mislead managers as well as economists.

To summarize, the TCE perspective is very narrow. It ignores processes and transformations inside the business enterprise, looking only at external supplier/alliance relationships, particularly bargaining over economic rent. While it is not a major foundational underpinning of dynamic capabilities, it has been influential and is useful in its appropriate application.

2.3.2 Evolutionary Routines

Organizational, cultural, and leadership skills are required to support organizational agility, transformation, and renewal. These skills and capabilities cannot be put into action overnight, in part because an organization tends to carry along its own legacy as it moves forward. Sometimes a radical break is worth trying if circumstances demand it. But that is as likely to create its own set of problems.

This idea that the past casts a shadow into the future is part of evolutionary economics. It is most closely associated with two heterodox economists, Richard Nelson and Sidney Winter (Reference Nelson and Winter1982). In their model of the firm, the primary activities are building and exploiting knowledge assets, including organizational “routines.” Organizational learning, in the form of processing information and solving problems, leads to new knowledge and improved routines. Because routines evolve, each firm generates a unique trajectory. Some firms are better at learning, and some firms learn the wrong lessons and eventually fail.

The routines-based approach of Nelson and Winter was an early attempt to illuminate organizational knowledge and, indirectly, organizational capabilities. However, routines, in their view, are rather static and sometimes so mired in path dependence that managers are unable to change course when necessary. This puts the routines-based approach of Nelson and Winter more in line with the organizational ecology perspective of Hannan and Freeman (Reference Hannan and Freeman1977) than with the dynamic capabilities framework. For Hannan and Freeman, change occurs in a population of firms only through “selection” among incumbents and entrants, not through firm-level adaptation or through entrepreneurial asset orchestration and the shaping of the business environment.

The dynamic capabilities framework acknowledges evolutionary thinking (and therefore recognizes some degree of path dependence), but it is a bit more optimistic and recognizes the ability of managers to be entrepreneurial and modify the design of the firm, and sometimes even its environment (Augier and Teece, Reference Augier and Teece2008). With organizational learning, managers can have flashes of insight that, with board support, allow them to create new markets and transform not just their organizations but also market regulation and the attitudes of the firm’s partners and customers (Denrell, Fang, and Winter, Reference Denrell, Fang and Winter2003; Penrose, Reference Penrose1959). Such transformation capabilities are a source of strategic renewal, allowing the enterprise to stay relevant (Teece, Reference Teece, Tuncdogan, Lindgreen, Bosch and Volberda2019a). They are a function of many factors, including governance, especially the nature of engagement by the board of directors.

In this way, the dynamic capabilities framework endeavors to integrate the evolutionary and entrepreneurial perspectives. Each brings something different. While evolutionary models sometimes allow adaptation to the environment, the dynamic capabilities approach also recognizes the ability of entrepreneurial managers to reshape their enterprise and even their business environment.

2.3.3 Organizational Behavior

The organizational design challenges that can hamper transformation capabilities are studied in the field of organizational behavior (OB). This is a major area of research that analyzes the way individuals and groups behave in an organizational setting. OB has its roots in research done in the 1920s. Management up to that time was largely focused on operational efficiency (and not innovation), as exemplified by the “scientific management” principles of Frederick Taylor (Reference Taylor1911).

In a classic OB study, Burns and Stalker defined two ideal types of organizational structure. One was called “mechanistic,” which meant clear divisions of labor, centralized authority, and steep hierarchy. The alternative was called “organic,” which they used to mean an organization where individual roles are loosely defined, decision making is decentralized, and the authority structure is relatively flat. While mechanistic organizations are suitable for the pursuit of efficiency in stable markets, organic structures are better for flexibility in more dynamic environments. Put differently, organic structures support dynamic capabilities.

Some companies have successfully designed bureaucratic (mechanistic) structures for innovation (e.g., Eisenhardt and Tabrizi, Reference Eisenhardt and Tabrizi1995), but most companies have difficulty balancing bureaucracy and innovation as they grow. Even tech leader Google, according to a stream of insider complaints and other reports, is finding its innovation hampered by bureaucracy.Footnote ⁶ Studies (e.g., Wilden et al., Reference Wilden, Gudergan, Nielsen and Lings2013) have also looked at how a mechanistic structure can hinder the effectiveness of a company’s dynamic capabilities more generally.

OB has three levels of analysis: the individual, work groups, and the organization (and society). Subjects include how different types of employees can be motivated, how teams can be managed effectively, how organizations can be designed, how to overcome resistance to change, and how to maintain a productive organizational culture.

In the 1930s, a number of scholars began to explore aspects of work beyond efficiency-oriented time and motion studies. Management experts such as Mary Parker Follett (Reference Follett and Metcalf1926), Elton Mayo (Reference Mayo1933), and Chester Barnard (Reference Barnard1938) emphasized the cooperative nature of organizations and the importance of the relations among people within them. Workers could be motivated not just through money or close supervision but also by leadership and opportunities for recognition.

There are many other topic areas within OB. One particularly important subject is how decisions are made. Economists tended to assume fully rational decision making by corporate managers. A particularly successful response to this was Nobel Prize winner Herbert Simon’s concept of “bounded rationality,” which recognized that decision makers are seldom able to consider a problem in all its dimensions in the perfectly optimal manner assumed in economics models (Simon, Reference Simon1957). This was embraced by other scholars, such as Richard Cyert and James March, who published an influential management book about how organizational decisions are actually made (Cyert and March, Reference Cyert and March1963).

A mastery of OB issues, along with the relevant economics, is vital for building an organization with strong dynamic capabilities. OB teaches, for example, that flatter hierarchies, without layers of middle management, are generally able to make faster decisions as part of the process of seizing opportunities. And an organizational culture that embraces change, values input from all employees, and recognizes that failure is part of learning is more likely to transform readily when necessary. Meanwhile, economics teaches that incentives, governance, asset specificity, technology, and numerous other factors matter, too. When it comes to transformation, the dynamic capabilities framework is where these disparate approaches can be happily, if not neatly, joined.

All this is not to say that building dynamic capabilities in an organization and in a management team requires formal instruction. Senior executives in Silicon Valley have dynamic capabilities implicitly, almost by birthright. I’m simply identifying them explicitly in order to facilitate their more universal diffusion and extension.

4.1.1 Deep Uncertainty

Deep uncertainty is ubiquitous in today’s complex, interdependent business world. Major unexpected shocks, dubbed “Black Swan events” by financial theorist Nicholas Taleb (Reference Taleb2007), occur “outside the model.” Yet, as Taleb argued, such events often drive changes in the fortunes of countries and companies.

While large-scale shocks are rare, smaller shocks are fairly frequent. Small, frequent, and unanticipated shocks are particularly common in the technological arena. All industries are competing in a world where capabilities have spread to more geographic regions than ever before and interconnectedness can propagate shockwaves from once-obscure corners of the globe to major markets in the turn of a news cycle. As venture capitalist William Janeway (Reference Janeway2012, p. 105) noted, “the Innovation Economy … is saturated in unquantifiable uncertainty.”

Nearly a century ago, Frank Knight recognized:

Practically all of the traditional approaches to the firm implicitly assume relatively predictable environments. These approaches may recognize risk, but they ignore deep uncertainty. In effect, they assume that uncertainty can be managed in the same way as risk. Accordingly, they are of little help to managers figuring out how to compete in environments characterized by technological ferment, financial volatility, and other sources of disruption. They will misinform regulators and policy makers trying to craft regulations to control firm-level behavior and market outcomes.

Deep uncertainty is the type of operating environment then-US Secretary of Defense Donald Rumsfeld characterized in 2002 by the term “unknown unknowns.”Footnote ¹⁵ A known unknown is when one is missing vital knowledge that could nonetheless be known, given enough time and resources. For example, in the Battle of Midway, both sides knew the enemy fleet existed, but they did not know where. In contrast, an unknown unknown is when we haven’t even thought of the possible event.

Uncertain events do not always result in negative outcomes. A large, unexpected event might also be positive, such as when a consumer-generated online video “goes viral” and creates massive demand for a toy or when Chinese artificial intelligence company DeepSeek launched a large language model developed at a fraction of the cost of OpenAI’s ChatGPT. However, as any small company unable to take advantage of a sudden temporary surge in demand knows, positive shocks also require agile management and flexible organizations.

There is limited short-term financial protection available to guard against such uncertainty, or to embrace unexpected opportunity. Holding cash, for example, is a good hedge against positive or negative surprises, but it provides only short-term relief. Managers must still identify a path forward. Managing under deep uncertainty calls for the use of “art” as well as science. Reason and analysis are in the toolkit, but imagination is also required. In effect, navigating the unknown often involves imagining a future and endeavoring to build it.

The dynamic capabilities framework acknowledges uncertainty. That is why it prioritizes figuring out what to do when the trajectory of the business environment is uncertain and ambiguous. Many firms have proved unable to act under such conditions, which are simultaneously treacherous and full of opportunity.

When faced with deep uncertainty, doing things efficiently is of secondary importance. Yet, in companies with weak dynamic capabilities, much attention remains focused on efficiency and optimization.

To build and sustain competitive advantage, managers need to foster an organizational ability to navigate unexpected events. Many firms resort instead to crisis management, which is often all-consuming and deflects management from engaging with the full range of opportunities. What is required for sustained profitability is for the business enterprise be built to respond to the unexpected. Flexible, resilient, and opportunity-seeking (entrepreneurial) systems are a hallmark of strong dynamic capabilities.

4.1.2 Non-Priced Assets

In mainstream economics, price theory holds that with (perfect) competition it is impossible to purchase something for less than it’s worth or for less than the long-term costs of producing it. If the real world looked like that, it would not support prosperity. Without the possibility of economic rents, entrepreneurial enterprises could not flourish. Yet perfect competition is precisely the condition that competition authorities allegedly seek to emulate.

In reality, and without appealing to monopoly theory, it is often possible to acquire something for less than it’s worth to the buyer if the acquiring firm owns related specific complementary assets for which there is no established market.

And this is neither unusual nor unlikely. Most strategic assets have no market price in isolation because the value of an asset is context-dependent. Such assets generally yield their full value to the owner only when they are combined with other complementary or cospecialized assets. If markets for strategic assets exist at all, they are generally thin.

It is well understood that the price system’s normal asset allocation role is unlikely to occur properly when asset values depend on idiosyncratic combinations without sufficient buyers and sellers to generate a market price. An economic implication of this is that input or factor markets are not fully efficient, and the factor markets will not serve their coordinating function. The entrepreneurial manager, not a Walrasian auctioneer, achieves the micro-level coordination on which the economy depends.Footnote ¹⁶ And the market inefficiency opens the way, if the entrepreneur has correctly sensed and seized opportunities, for supernormal profits derived not from arbitrage but from innovation and/or superior management acumen.

Intangibles assets are a particularly important class of strategic assets for which markets are very thin or nonexistent (Teece, Reference Teece1981, Reference Teece, Bounfour and Miyagawa2015). This is only partially due to the limited nature of the property rights assigned to them.

Certain knowledge assets, such as context-dependent technological capabilities, cannot be meaningfully secured without acquiring a company or business unit and associated key personnel. Even if prices did reflect all information, the thin-market phenomenon (i.e., the small number of participants) would still result in wide valuation ranges (the bands in which a “competitive” price might fall) as long as firms are heterogeneous and products are differentiated. This is the setup implicitly adopted in the strategic management literature (Denrell, Fang, and Winter, Reference Denrell, Fang and Winter2003; Rumelt, Schendel, and Teece, Reference Rumelt, Schendel and Teece1991; Teece and Winter, Reference Teece and Winter1984). Modern auction theory (e.g., Klemperer, Reference Klemperer2002) likewise recognizes that assets will not achieve their full value in an auction if there is only one buyer.

4.1.3 Complementarity and Coordination

Technological complementarities impose coordination, market design, and control challenges. Alignment of activities within firms is required. Alignment among firms is also necessary where certain types of complementarities exist.Footnote ¹⁷

External alignment issues were raised decades ago at the most general level by Boulding (Reference Boulding1956), then specifically by Malmgren (Reference Malmgren1961) and Richardson (Reference 73Richardson1972). Thereafter, they were echoed by Williamson (Reference Williamson1975), remarked upon by Teece (Reference Teece1984, Reference Teece1990), explored empirically to a limited degree by Armour and Teece (Reference Teece1980) and Helfat and Teece (Reference Helfat and Teece1987), emphasized in a vertical relation to general-purpose technologies by Bresnahan and Trajtenberg (Reference Bresnahan and Trajtenberg1995) and Helpman (Reference Helpman1998), but never fully explored or developed by economists or management scholars. The economics literature tends to assume that, in the main, upstream and downstream investment expectations will converge, which seems unlikely given the proprietary (and hence at least partially secret) nature of much of knowledge required for investment activity.Footnote ¹⁸

In the economically significant realm of enabling and general-purpose technologies, these alignment problems are particularly severe. Bresnahan and Helpman are among the few pointing out potential contractual and market failure issues that may lead to underinvestment. With reference to this class of widely applicable technologies, Jones (Reference Jones, Lerner and Stern2012, p. 660) noted that the main problem for capturing value by exploiting the application of an innovation in many downstream sectors is “the fact that you cannot identify the recombinant possibilities ex ante means that you cannot easily solve the bargaining problem in practice – you cannot integrate your way around it. So innovation faces a serious market failure in the sense that socially profitable innovation does not occur.”

In short, the market, and perhaps even vertical (and horizontal) integration, cannot ensure socially optimal innovation and adoption of general-purpose and enabling technologies.

From a managerial perspective, there is a similar lacuna regarding “alignment.” Some of these concerns are addressed under the heading of business model issues (Teece, Reference Teece2010a), leaving it to entrepreneurs to design creative organizational arrangements to help solve the coordination and associated appropriability challenges. When the coordination/integration challenges are external, private ordering (contractual) solutions are possible in some – but not all – cases.

Economic theory has yet to address these pervasive market imperfections in a meaningful way, particularly as regards their implications for the theory of the firm, the role of the manager, and the challenges associated with innovation. Hints about these matters can be found in Richardson (Reference 73Richardson1972) and in the literature on entrepreneurship (e.g., Kirzner, Reference Kirzner1997) and that on general-purpose technological innovation (Bresnahan and Trajtenberg, Reference Bresnahan and Trajtenberg1995; Helpman, Reference Helpman1998; Jones, Reference Jones, Lerner and Stern2012). What is missing is an effort to tie these disparate threads into a theory of the firm that includes the decisive role of managers. The dynamic capabilities framework can move the theory of the firm in that direction (Teece, Reference Teece, Rosenberg and Hall2010b, Reference Teece2017).

4.1.4 Managerial Asset Orchestration

Special value can accrue to the enterprise that achieves good internal and external asset alignment. Because many asset markets are thin, the value-enhancing coordination and alignment of assets/resources is difficult to achieve through the price system and is more easily accomplished by managerial fiat (i.e., with direct ownership of the assets). Achieving alignment through such internalization goes beyond what Barnard (Reference Barnard1938) has suggested as the functions of the executive. His was a limited view of managers, with their task whittled down, in the words of Williamson (Reference Williamson1993), to one of “cooperative adaptation.” Building and assembling assets inside the firm (as opposed to accessing them through a skein of contracts) is not done primarily to guard against opportunism and recontracting hazards, although in some cases that may be important. Rather, it is done to achieve economies of scope and appropriability benefits, which goes far beyond the conventional economic logic of minimizing Williamsonian transaction costs. This alignment process has incentive and organizational culture dimensions, too. It is meaningful that the basic unit of analysis for dynamic capabilities is not the transaction (as in transaction cost economics) but the entire firm (see Section 4.3.2).Footnote ¹⁹

In a capabilities-based theory of the firm, the concept of cospecialization between or among assets is particularly important (Teece, Reference Teece1986). Assets that are cospecialized need to be employed in conjunction with each other, usually inside the firm (Teece, Reference Teece1980).

Merely putting two business units or departments under common ownership and common governance need not bring about “integration” in the sense of achieving full alignment and cooperation. That requires wise managerial oversight and active coordination efforts to overcome the bureaucratic disadvantages of integration. The disadvantages Williamson identified include communication distortions, internal procurement hazards, internal expansion proclivities, and program persistence because “shifting the incremental transaction from the market to the firm generally results in greater budget-based supports, whence vertical integration gives rise to persistence tendencies” (Williamson, Reference Williamson1975, p. 122). His concluding comment was that

Some degree of integration capability (whether within a firm or among firms) is necessary for long-term survival. Successful functional integration can be tremendously hard, especially in contrast with disaggregation, which is often simple to accomplish. Growth will always involve more work on integration (which may be one reason why many managers settle for low growth). The entrepreneurial task of implementing value-enhancing “new combinations” inherently requires some measure of functional integration. The same is true for new business models and the introduction of new capabilities.

The challenge of functional integration is less formidable in smaller companies. The CEO/founder can use personal influence to help bring it about. As organizations become larger, the CEO must work through others to communicate goals, motivate employees, and propagate the organizational culture that underpins good alignment. As entrepreneur Peter Thiel has noted, this is hard to do, but he credits his fellow PayPal co-founder, Elon Musk, with these capabilities. With reference to Musk’s Tesla and SpaceX ventures, Thiel has said that “what was really impressive was integrating all these pieces together,” and that this “is actually done surprisingly little today and … when people can pull it off, is very valuable” (Thiel, Reference Thiel2014).

In the dynamic capabilities framework, rather than the single-minded pursuit of cost minimization, the distinctive role of the (entrepreneurial) manager is this “orchestration” of cospecialized assets and of business activities to achieve value-creating and value-capturing alignment. Performed astutely and proactively, such orchestration can: (1) keep cospecialized assets (and people) in value-creating alignment, (2) identify new cospecialized assets to be developed through investment, and (3) divest or run down cospecialized assets that no longer yield special value. These goals contribute to organizational prosperity and could not be readily achieved by accessing a similar set of assets through a web of contracts with external partners in part because of dynamic transaction costs (the costs of negotiating and so on) but also because there may not be a competent entity to build or supply the assets that are needed. And even if there were, accessing the assets via contracts would likely lead to what Williamson (Reference Williamson1975, Reference Williamson1985a) called a small numbers bargaining problem, which would undermine value capture. In other words, highly specialized capabilities must often be built because they cannot be bought (and there is limited utility in labelling this a transaction cost problem). Judging the best approach for accessing and coordinating necessary assets and effectuating their effective orchestration are critical functions of managers in the dynamic capabilities framework.

4.2.1 Introduction

As discussed in Section 3, economic models typically use a “representative firm” abstraction to explore market structures of perfect competition and oligopoly. While it has long been recognized that most industries contain “strategic groups” of firms pursuing similar business models (Porter, Reference Porter1979) for which a representative firm assumption might be benign, that assumption can shed no light on the considerable heterogeneity among firms across an entire industry. A theory that cannot account for the differences among, for example, Tesla, Mercedes-Benz, General Motors, Honda, and Hyundai is of limited utility for explaining behaviors and outcomes in the automotive industry.

This heterogeneity has roots in both demand- and supply-side factors. Differences among firms often reflect the fact that firms target different customer segments with different needs. Thus, in autos, Volkswagen competes for different customers than Rolls-Royce, and this requires different production technologies and different marketing and sales methods. Even when firms are pursuing the same or similar market segments, they may opt for different technological and organizational approaches, use different business models, and choose different strategies for any number of reasons. Such (strategic) decisions by managers establish different pathways, leading to interfirm heterogeneity.

Deep uncertainty also drives interfirm differences. Technological uncertainty renders decisions relating to innovation complex, and different firms make different decisions because of how each management team reads the situation (Rosenberg, Reference Rosenberg1982; Teece, Peteraf, and Leih, Reference Teece, Peteraf and Leih2016).

The dynamic capabilities framework thus recognizes the distinctive role of managers in asset orchestration and recombination. In endeavoring to build a theory of the firm without fully acknowledging the economic importance of internally managed coordination, Williamson, Jensen, and others have deflected attention away from the important role that the business enterprise, led by entrepreneurs and managers, plays in allocating resources as it expands the economy’s existing set of possibilities.

By contrast, neoclassical economics treats managers as little more than a set of algorithms. To determine production levels, they use the point where marginal revenue equals marginal cost. They set wages equal to the marginal revenue product of labor. They optimize capital structure using the relative prices and tax treatment of equity and debt. The contrast of these rules with the vital roles that managers play in real firms (and in the dynamic capabilities framework) couldn’t be more stark.

4.2.2 Sensing, Seizing, and Transforming

The sensing, seizing, and transforming capabilities of managers and their organizations bring learning and leadership into the theory of the firm. Most importantly, they are the critical factors that distinguish between what can be done inside the firm as opposed to what is possible under a system of pure contracts.

“Sensing” is an inherently entrepreneurial set of activities that involves exploring technological opportunities, probing markets, and listening to customers, along with scanning the other elements of the business ecosystem. It requires management to build and test hypotheses about market and technological evolution, including the recognition of latent demand. The world wasn’t clamoring for a coffee house on every corner, but Starbucks, under the guidance of Howard Schultz, recognized and then successfully developed and exploited the potential new market. As this example implies, sensing requires managerial insight and vision – or an analytical process embedded in the enterprise that can serve as a proxy for it. Sensing benefits from the application of data analytics and artificial intelligence to real-time market data to spot trends, anomalies and patterns. The ability to sense different ways of doing things is the precursor to choosing among them.

Once opportunities are sensed, choices must be made, and investment follows. The structure and assets of the organization help shape the choices made. “Seizing” includes designing and implementing a business model to satisfy customers, shape markets, and capture value. Large cash balances, or ready access to external capital, provide financial flexibility that aids dynamic capabilities. Top talent helps. Employee motivation and cultural alignment are vital. Good incentive design is a necessary but not sufficient condition for superior performance in this regard; good leadership is critical. Strong external relationships must also be forged with suppliers, complementors and customers, with the boundaries of the firm drawn to avoid (or at least limit) the loss of profits to the owner of an external “bottleneck” asset (Teece, Reference Teece1986).

Sensing and seizing are similar to exploration and exploitation, two activities discussed in the organizational behavior literature as potentially incompatible inside a single organization (March, Reference March1991). Exploration (e.g., research on a potentially disruptive technology) has a longer time horizon and greater uncertainty than exploitation (e.g., selling mature products). The two types of activities require different management styles. One solution is an “ambidextrous organization” where two separate subunits with different cultures are linked by shared company-wide values and senior managers with a broad view (O’Reilly and Tushman, Reference O’Reilly and Tushman2004, Reference O’Reilly and Tushman2013). But the tensions between subunits must still be astutely managed so that the integrated structure reaps the full learning benefits.

A firm’s “Transforming” capabilities draw on management’s leadership skills in order to avoid undermining employee morale. The need for a realignment of the enterprise’s resources is most apparent when radical new opportunities are to be addressed. But more modest changes are needed periodically to soften the rigidities that develop over time from asset accumulation, standard operating procedures and insider misappropriation of rent streams. A firm must also maintain strategic alignment vis-à-vis its ecosystem. Complementarities need to be constantly managed and reconfigured as necessary to achieve evolutionary fitness, limiting loss of value in the event that demand shifts in a way that favors external complements.

Existing theories account for a firm’s configuration at a point in time, possibly allowing for its response to a one-time change such as a shift in transaction costs. Few economists, though, have attempted to build a theory of the durable growth of the firm. The incorporation of dynamic capabilities (sensing, seizing, and transforming) in a theory of the firm as a set of ongoing activities opens avenues for the firm to evolve in response to any number of shocks and to compete on the basis of innovation, not just cost minimization.

4.2.3 The (Normative) Economics of Organizational AgilityFootnote ²⁰

The dynamic capabilities framework indicates a set of principles that entrepreneurial managers should and usually do understand. In particular, managers must recognize that the pursuit of agility (which entails speed, flexibility, and resilience) often puts ordinary and dynamic capabilities in conflict. Observers note that “in attempting to preserve their source of advantage, organizations can overcommit to institutionalization, making them more inert and vulnerable to environmental shifts” (Worley, Williams, and Lawler, Reference Worley, Williams and Lawler2014). Achieving organizational agility, however, can require sacrificing technical efficiencies in favor of assets and structures that can be more easily redeployed when necessary. The net benefits (that is, benefits minus costs) of organizational agility increase with the degree of uncertainty in the organization’s competitive environment.Footnote ²¹ Strong dynamic capabilities can yield organizational agility while minimizing the cost of achieving it.

The trade-off between agility and efficiency is only sometimes recognized in the field of economics (e.g., Stigler, Reference Stigler1939). It has likewise received insufficient attention in the field of strategic management and is almost never mentioned in organizational theory. The closest parallel is the trade-off between efficiency and innovation addressed in the organizational ambidexterity literature by Michael Tushman, Charles O’Reilly, and colleagues (e.g., Benner and Tushman, Reference Benner and Tushman2003; Tushman and O’Reilly, Reference Tushman and O’Reilly1996). Only very limited attempts have so far been made to offer prescriptive advice to managers regarding how to negotiate the agility-efficiency trade-off.

An important issue is what level of agility is worth pursuing, given that maintaining agility comes with ongoing costs (see, e.g., Ifandoudas and Chapman, Reference Ifandoudas and Chapman2009). Not all business environments involve deep uncertainty at all times. A relatively calm environment allows for “business as usual” to carry on indefinitely. Every organization, though, wants to be ready for agile change when needed, which should inform choices such as asset purchases and organizational design. Manufacturers, for example, can invest in more flexible types of plants and equipment that can deal with frequent changes in the rate of production and be fully or partially redeployed as requirements shift. In other cases, agility will be sacrificed to aid strategy, as in the case of commitments to production capacity.

An excellent example of the interdependence of agility (a capability) and strategy taken from the military context is the Battle of Trafalgar (off Cape Trafalgar, Spain) in 1805. This was a naval engagement fought by the British Royal Navy against the combined French and Spanish fleets during the Napoleonic Wars. Historians never fail to give credit to the British Admiral Lord Nelson’s strategy: engaging the enemy fleet by dividing his smaller force into two columns directed perpendicular to the larger enemy fleet – a complete break from prevailing tactical orthodoxy (which was to engage parallel, in a single line). Less frequently mentioned is that in pursuing this strategy, Admiral Nelson hoped to isolate the enemy’s flagship (leading to a lack of coordination) and create chaos on the water. In the ensuing chaos, there would necessarily be ship-to-ship actions, in which Admiral Nelson’s more agile ships and crews would have a better chance. Lord Nelson knew that the better seamanship and faster reloading speeds of the Royal Navy gunners would play a key role. The strategy would favor his ships’ and his crew’s capabilities over their Spanish and French adversaries. In short, Admiral Nelson’s strategy leveraged the more agile capability of his naval force. Despite a smaller number of ships, he was able to pull off a decisive victory.

Lord Nelson’s victory at Trafalgar was not through strategy alone, as is often assumed, but from the marriage of strategy with capabilities (and, in particular, agility). Agility can be costly and will not yield commensurate benefits unless married to a good strategy.

As this example suggests, the level and type of agility that (entrepreneurial) managers choose to build into their organizations and maintain should depend not just on the uncertainty in the business environment but also on their strategy, on the firm’s positioning in the market, and on the weighting assigned to downside and upside risks. That said, firms with strong dynamic capabilities will be better at sensing emerging developments, helping them to achieve agility with less sacrifice of efficiency.

The dynamic capabilities framework, which encompasses strategy, helps to understand when to build agility in, when not to, and when to sacrifice it. The framework highlights interrelationships that help set priorities and enable coherence and congruence between strategy, structure, and the business environment.Footnote ²² This is a complex balancing process with no single “best” arrangement. Hence, each firm, based on its management, its legacy elements, and its current circumstances, will solve the challenge in a distinctive fashion.

4.2.4 The Foundations of Firm-Level Heterogeneity

With the dynamic capabilities framework, I believe that we are a few steps closer to a truly fundamental understanding of the origins of firm-level heterogeneity and the sources of enterprise-level value creation, value capture, and value distribution, along with durable growth. No other framework is as ambitious in its reach.

Uncovering the origins of long-term cash flow generation is the deepest inquiry in microeconomic and financial theory. It is the concern that directly and indirectly animates management theory and investment choices and motivates the quest for understanding the ways that actual enterprises are far from their too-frequent representation as interchangeable black boxes.

A top management team determines the path and character of an organization. At any given date, the top management team of a particular enterprise is unique to it alone. While the organization and its capabilities provide managers with the raw material required to perpetuate the enterprise, it is incumbent on top management to make the key decisions as to whether the enterprise is currently making the right products and addressing the right market segment and whether its future plans are appropriately matched to consumer needs and technological and competitive opportunities. Top management must develop conjectures, validate them, and realign assets and competences for new requirements, as well as shaping the internal culture in which the generation and sharing of knowledge take place. The combined dynamic capabilities of the managers and the organization enable the enterprise to profitably orchestrate its resources, competences, and other assets particularly those that are co-specialized (Pitelis and Teece, Reference Pitelis and Teece2009).

The business processes at the heart of capabilities can be unique and firm-specific. These unique processes are sometimes called “signature processes” (Gratton and Ghoshal, Reference Gratton and Ghoshal2005). I introduced them earlier in the context of superordinary capabilities, but such processes can also be part of the firm’s dynamic capabilities. They develop from the firm’s past activities, irreversible investments, and embedded values, which constitute a distinct organizational heritage. They are also influenced by the needs of the particular customer segments that a business enterprise chooses to target.

The basis of signature processes in past managerial decisions tends to make them difficult for competitors to imitate. Sooner or later, though, if they are good, they will be copied. The Toyota System of Production, which was eventually matched by US and European automotive firms, is one such example. However, the replicability of any complex process is sometimes confounded by what Lippman and Rumelt (Reference Lippman and Rumelt1982) call “uncertain imitability” because even the people involved may not fully understand the complementarities underlying a specific capability. This, along with a high tacit component to the underlying knowledge, may keep a signature process effectively proprietary for quite some time, providing at least a temporary source of interfirm heterogeneity.

4.3.1 Nontradable Assets

For Williamson, the determination of what belongs inside and outside the firm is based on transaction costs, including the costs and risks of writing contracts with buyers, suppliers, and alliance partners. In the dynamic capabilities framework, the selection of what to organize internally versus via alliances or the market depends on the availability and the nontradability of assets, on capabilities, and to some extent on what Langlois has termed “dynamic transaction costs,” namely, “the costs of persuading, negotiating, coordinating and teaching outside suppliers” (Langlois, Reference Langlois1992, p. 113).

The notion of nontradability (related to the issue of non-priced assets in Section 4.1.2) does not precisely match Williamson’s concept of transaction costs because there are reasons beyond the asset specificity analyzed by Williamson that assets, particularly intangibles, will be nontraded or thinly traded. For example, there may simply be no viable business model for licensing certain types of know-how, or certain assets may be so idiosyncratic that they aren’t productive anywhere else.

Moreover, many companies will simply not license “strategic” technological assets, such as Coca-Cola’s secret formula for its namesake beverage concentrate, at any price. One reason might be that both parties are able to sell in the same territory and territorial restrictions are not allowed in a contract (possibly for antitrust reasons) or are not enforceable at low cost. Theoretically, a licensor ought to be indifferent between own sales and the sales of a licensee if the royalty rate is set to enable royalties to equal lost profits. However, such arrangements are rarely, if ever, seen, in part because there is likely to be ambiguity with respect to which customers and what sales are actually lost to the licensee. There are also likely concerns about the licensee rather than the licensor capturing the “learning by using” know-how associated with exploiting the technology. More generally, technology licensing may not be feasible due to differences in expectations with respect to the technology’s profit potential. This may open such a wide bargaining range that the positions never converge and no transaction can occur.

As Williamson’s framework suggests, negotiating, contractually specifying, and monitoring any sharing arrangements are also likely to be very difficult. However, such contract-related transaction costs do not address the competitive and knowledge-related challenges associated with the licensing of strategic technologies described in the preceding paragraph. Thus, it is rare that firms will be able to rely entirely on an unbundled business model in which the licensing of patents or trade secrets can be used as a mechanism to capture value from know-how. Rambus, Inc, and Dolby Labs are amongst the exceptions, and both these companies have had challenges.

4.3.2 Level of Analysis

Another distinction between dynamic capabilities and transaction costs is the level of analysis. The basic unit of analysis for dynamic capabilities is not the transaction (as in transactions cost economics) but the firm (and its business environment). This orientation allows a capabilities-based analysis of internal and external alignments, which is a necessary condition for correctly analyzing the value-enhancing potential of cospecialized assets. A firm-level perspective allows an emphasis on production, learning, and innovation, while transaction cost economics is limited to the analysis of contracts and risks. The dynamic capabilities framework is less concerned with avoiding opportunism and more concerned with embracing opportunity.

This difference in level of analysis can be seen in terms of how the boundaries of the firm are analyzed. The question is usually framed in terms of vertical supply relationships: should a particular activity be conducted in-house or outsourced? But at the level of the firm, the question is also one of horizontal scope: in what product markets should a firm compete?

Teece et al. (Reference Teece, Rumelt, Dosi and Winter1994) provided a capabilities-aware framework that endeavored to account for the horizontal boundaries of the firm based on learning, path dependencies, technological opportunities, the selection environment, and the firm’s position in complementary assets. Management’s ongoing reassessments of the firm’s coherence in product space are part of its dynamic capabilities.

4.3.3 Cospecialized Assets

As discussed in Section 4.1.4, Williamson recognized that cospecialized assets may require a single owner, but he retained a bias for market-based contracting below some undefined threshold. In prior research on technology management and the boundaries of the firm, Teece (Reference Teece1980, 1982, Reference Teece1986) saw cospecialized assets as important building blocks to explain differences in firms’ technology strategies and capabilities.

Building and assembling cospecialized assets inside the firm (rather than accessing them through a skein of contracts) is not done primarily to guard against opportunism and recontracting. Instead, because effective coordination and alignment of assets is difficult to achieve through the price system, good alignment is better accomplished inside the firm. Performed astutely and proactively, the orchestration of cospecialized assets by entrepreneurial managers can: (1) keep cospecialized assets in value-creating and value-capturing alignment; (2) help identify new cospecialized assets to be developed through investment; and (3) support the divestment or running down of cospecialized assets that no longer yield special value. These goals cannot be readily achieved through contractual mechanisms in part because of dynamic transaction costs (the costs of negotiating, etc.) but also because there may not be a competent entity to build or “supply” the assets that are needed in the first place (i.e., the markets are too thin or simply nonexistent). In other words, capabilities must often be built, they cannot be bought, and there is limited utility in labeling this conundrum as a transactions cost problem.

Rather than stressing opportunism (while noting that opportunism must still be guarded against), the emphasis in dynamic capabilities is on investing and, in particular, building specialized assets (that often cannot be bought) and on effectuating changes needed to keep the enterprise aligned with its business environment. Such changes include research and development, redesigning the business model, and asset selection.

4.3.4 The Coordination of Systemic Innovation

A related consideration is the choice of whether to rely on external suppliers for complementary innovations. This is related to what Richardson (Reference Richardson1960) and Williamson (Reference Williamson1975) have called “convergence of expectations.” Complementary innovations require investments in research and development to be coordinated, which can be difficult to effectuate using contractual mechanisms.

Coordination is of greatest concern when innovation is systemic (Teece, Reference Teece1984). Systemic innovation involves elements of a system for which the designs must be harmonized due to their technological interdependence. The interdependence can be intrinsic. An airplane, for instance, is a complex assembly of parts and subsystems with extremely tight tolerances. If not designed holistically, problems are likely to emerge late in the process and require considerable resources to identify and fix. In other cases, interdependence can result from the choice of a business model. In smartphones, Apple chose to keep its operating system and hardware intimately linked, while Google concentrated on software that it could license to multiple phone manufacturers. As the Apple example suggests, a systemic design process need not be a barrier to the outsourcing of production.

Autonomous innovations, which do not require coordinated activities between parties, can occur quite easily inside separate organizations then be “plugged in” to the bigger project thanks to public or private interface standards. For example, the open architecture of the IBM personal computer allowed competitive innovation to thrive for many of its subsystems, including hard drives and monitors.

In some cases of systemic innovation, the involvement of one or more specialized partners in the design process is unavoidable. The lenses in semiconductor manufacturing equipment come from specialists such as Germany’s Zeiss, which must co-design a subsystem with an equipment maker such as ASML of the Netherlands for use in ASML’s microchip lithography tools. The collaboration of multiple enterprises in a systemic innovation introduces many hazards that do not comfortably fit within the rubric of transaction costs. Delays are common and may result from miscommunication, limited capabilities, and divergent goals amongst the parties.

Harmonization of development among firms is particularly difficult when capabilities are very unequal. Boeing discovered this to its cost when it decided to rely on a global array of suppliers to develop parts for its new 787 Dreamliner as a cost-sharing measure; some suppliers lacked the capabilities to develop parts of the necessary quality, and Boeing had cut back its monitoring capability. Deficits in the capabilities of suppliers resulted in years of delay (Michaels and Sanders, Reference 72Michaels and Sanders2009). It is not entirely clear, from the perspective of theory, whether this is best viewed as a contracting problem or a capabilities issue. However, the latter appears to be more powerful.

The Boeing experience echoes Lockheed’s experience three decades earlier when the L1011 wide bodied plane was delayed by the failure of Rolls Royce to develop and deliver on time the RB211 jet engine for the L1011, effectively putting Lockheed out of the wide-bodied civilian aircraft industry. This was not an exercise of opportunism by Rolls Royce; rather it reflected Rolls Royce’s lack of ability to achieve ambitious technological goals.

In the presence of these hazards, maintaining technological control of the innovation trajectory sometimes requires vertical integration (and heavy investment in R&D). When this is not possible, the dynamic capabilities framework points to (re)shaping the industry’s architecture through measures such as corporate venture investments in the supply base to build a competitive market for key complements (Pisano and Teece, Reference Teece2007).

4.3.5 The Coordination of Knowledge Workers

Inside the enterprise, transaction cost economics and other contractual perspectives on the firm see employees as more or less interchangeable. A tradition dating back to Alchian and Demsetz (Reference Alchian and Demsetz1972) emphasizes that teamwork, monitoring and coordination are facilitated by occurring inside a firm, where shirking can more easily be monitored. This branch of the theory of the firm tends to focus on incentive design and verification.

However, this approach ignores how the firm’s expert talent – the knowledge workers providing the creative solutions to the firm’s challenges – must be managed (Teece, Reference Teece, Burton-Jones and Spender2011b). Managing expert talent has less to do with metering and monitoring to detect and punish shirking and other forms of opportunism than it has to do with detecting, monitoring, and calibrating potentialities.

Alchian, Demsetz, and Williamson have all emphasized opportunistic free riding as the key hazard to guard against. Williamson assumes, correctly, that human actors are boundedly rational and self-interested.

By contrast, the dynamic capabilities framework emphasizes other traits of human nature, namely (1) entrepreneurship and willingness (when properly incented) to pursue high-risk/high-reward opportunities, and (2) foresight and acumen. These are undoubtedly less ubiquitous and evenly distributed than self-interest, but they are far more salient for value creation and must be recognized and cultivated by managers using a light touch.

In the dynamic capabilities framework, opportunism is not held in abeyance, nor are incentive issues ignored. But these are usually of secondary importance. The long-term viability of the firm is of prime importance, and it lies in the generation, configuration, and leveraging of knowledge assets, including human capital.

4.3.6 Beyond the Boundaries of the Firm

While the analysis of the boundaries of the firm captures many key elements of managing value creation, the fundamental problems to be solved by the firm are the design and implementation of value capture strategies in an uncertain environment. These strategies must overcome any appropriability problems and help create the new organizational capabilities needed to address fresh opportunities. While this is plainly in the realm of strategic management and dynamic capabilities, it is also basic to the nature of the firm.

The advantages of organizing economic activity inside the firm go well beyond savings in transaction costs. In particular, the advantages flow from the ability of entrepreneurial managers to combine idiosyncratic assets that are cospecialized and often nontradable to create and capture value by offering distinctive services (solutions) to customers while ensuring a return on investment adequate to fund ongoing activities. To a first approximation, the concerns of transaction cost economics are unnecessary baggage. For instance, if one wants to understand issues surrounding creating value, not simply protecting value created, transaction costs are at most a fraction of the story. The firm’s routines for sensing, seizing, and transforming can provide a basis for profitability well beyond the efficient minimization of contracting costs and hazards.

Opportunism is controlled not just through metrics and monitoring, but also through high commitment cultures. A transaction-level theory cannot encompass such enterprise-scale phenomena. Innovative firms typically need strong values because it’s hard in the loosely structured internal environments that innovation requires to define and measure performance and implement rigid controls. Creative and entrepreneurial activity need to be rewarded as well as encouraged. But creative talent thrives in a high-trust environment with challenging objectives.

The dynamic capabilities framework suggests a new theory of the firm, that is nonetheless consistent with the observation of the pioneering Cambridge University economist Alfred Marshall (Reference Marshall1898, p.213) that “capital consists in a great part in knowledge and organization: and of this some part is private property and the other part is not. Knowledge is our most powerful engine of production—organization aids knowledge.” Sadly, Marshall’s deep understanding of the firm fell by the wayside as his modeling exercises inspired modern economics. The capabilities-based theory of the firm proposed here opens up the black box of the firm and challenges economic theory to analyze new dimensions of innovative and productive activity, including value capture as well as value creation.

Put differently, the dynamic capabilities framework paves the way for a “doing” theory of the firm. Mainstream economic theories of the firm are about the firm “being.” The static assumption of equilibrium in the traditional theory prevents any exploration of how the firm innovates and achieves profitability. Moreover, disequilibrium is the true state of markets as they experience successive waves of creative destruction. Understanding the processes and activities which enable firms to survive and prosper under uncertainty and disequilibrium are just as important if not more so than understanding why they exist or the boundaries and structures they have chosen. A dynamic orientation is critical.