Knowledge Assets and Competitive Advantage
This section looks more closely at how the dynamic capabilities framework connects resources to performance through the creation and capture of value in markets.
Creating value with innovation
Despite its obvious importance, a theory of how firms create value is largely missing from the standard economics literature. To the extent it is addressed, the industrial organization literature dwells almost entirely on the funding of R&D, figuring (implicitly) that the R&D expenditure is the main driver of innovation. However, R&D activity is only one of several factors likely to determine the generation of new ideas.9 The concept of dynamic capabilities—the sensing, seizing, and transformation that ongoing innovation requires—provides a broader framework to help one understand how firms create value.
Sensing is an entrepreneurial activity—whether conducted by a new or an existing firm—that involves the identification and conceptualization of opportunities both within and beyond prevailing technological paradigms (Teece, 2008). It involves cognition. As markets evolve, changes in consumer needs, product technologies, and the competitive positioning of other companies can threaten a firm’s existing position or open the possibility of a new or better one. In some cases, as stressed by Kirzner (1973), the entrepreneur/manager may have differential access to existing information relative to rivals. More often, sensing opportunities involves scanning, interpretation, and learning across technologies and markets, both ‘local’ and ‘distant’, that are also visible to rival firms (March and Simon, 1958; Nelson and Winter, 1982). O’Reilly et al. (2009) describe well how IBM learned from its mistakes, having missed several emerging new market opportunities despite being involved in their early creation.10
In reality, management teams often find it difficult to look beyond a narrow search horizon tied to established competences (Levitt and March, 1988). Henderson (1994) cites General Motors, Digital Equipment, and IBM as companies that faced major problems from becoming trapped in their deeply ingrained assumptions, information filters, and problem solving strategies. O’Reilly et al. (2009) put IBM’s problems down to six factors, including the lack of discipline for evaluating new business opportunities.11
Seizing an opportunity requires investments in development via further creative and/or combinatorial activity that addresses the opportunity with new products, processes, or services. It may involve building a necessary new competence or identifying an appropriate external alliance that can secure access to one. It can be aided by new organizational processes and structures, as IBM has discovered with its emerging business opportunities process. However, it took the leadership of Lou Gerstner to get this set up, indicating that it is not just routines and processes which undergird dynamic capabilities.
Transformation of the firm itself is the third capability required for creating (and capturing) value. Sensing and seizing marked out a path for the creation of value, but over time the firm still needs to periodically consider (and reconsider) its own ‘fit’ to the current opportunities it plans to exploit and the new possibilities it plans to explore (Siggelkow and Levinthal, 2005). Management must assess the coherence of the firm’s business model, asset structure, and organizational routines with respect to its environment. Yet commitment to existing processes, assets, and problem definitions makes this extremely hard to do, especially in a firm that is currently performing satisfactorily.
Organizational innovation can allow the firm to escape unfavorable path dependencies. These dependencies themselves limit the speed and scope of the innovations that can be implemented (Teece et al., 1994). Reconfiguring the firm is costly in terms of both money and morale. When a planned innovation is incremental, routines and structures can probably be adapted gradually. Stinchcombe (1990), for example, describes how firms may make small adjustments to their structure as new information progressively reduces environmental uncertainty. Radical organizational innovation can potentially be accommodated by a ‘break out’ unit where new capabilities are established before being introduced to the firm as a whole (Teece, 2000).
Organizational innovation has a long history. As Chandler (1962; 1977) and Williamson (1975; 1981) have chronicled, the large, multidivisional (M-form) organization has its roots in the development of line-management hierarchies by the nineteenth-century railroads, which needed a system to manage a continent-spanning organization. In the twentieth century, large corporations such as DuPont and General Motors gradually shifted from a functionally organized (U-form) structure to an M-form structure that relieved top management of responsibility for operational details. Related innovations such as the conglomerate and the multinational forms allowed organizations to span a wider array of activities and locations than ever before.
Organizational innovation has continued, with the benefits of greater decentralization being ‘rediscovered’ as the enterprise grows. John Chambers, the CEO of US network equipment company Cisco Systems, described how the management structure of Cisco changed some fifteen years after its founding: ‘In 2001, we were like most high-tech companies—all decisions came to the top 10 people in the company, and we drove things back down from there’ (McGirt, 2008).
Cisco developed a more decentralized and collaborative management system, with a network of councils and boards entrusted and empowered to launch new businesses, and incentives to encourage executives to work together flexibly. Chambers claimed that ‘these boards and councils have been able to innovate with tremendous speed’ (ibid.). Yet just a few years after saying this, Chambers dissolved the majority of the councils to overcome the bureaucratic sclerosis that had set in.
Organizational innovation is not only an important form of creating value but of capturing it as well. Armour and Teece (1978) showed that the petroleum industry firms that first adopted M-form structures retained a profit advantage until the innovation was eventually replicated generally throughout the industry by the early 1970s. Subsequent studies (Teece, 1981b) showed this same result across multiple industries.
Capturing value (profiting) from innovation
Companies that rely too heavily on creating value without an eye for the market will not perform well commercially. Many engineering-driven companies’ brilliant ideas have never found (or created) a market. Invention without a commercialization strategy and access on competitive terms to complementary assets is unlikely to lead to commercial success. Although it is possible to disseminate some innovations (e.g. software over the Internet) without using complementary assets, most industrial innovations will not achieve marketplace success without deployment of considerable resources and complementary assets into production, distribution, and promotion.
For the value capture process, ‘sensing’ includes detecting the right timing for market entry. In some cases it’s beneficial to be a first mover while in others it may be more advantageous to exploit a gap left by a pioneer.
‘Seizing,’ however, is the core competence cluster for capturing value and is encompassed by the profiting from innovation framework, which is discussed below. The capabilities involve choosing an appropriate mechanism for the protection of intellectual property (e.g. trade secrets versus patents), deciding which activities must be performed by the firm or procured in the market, and crafting a business model.
A business model (Chesbrough and Rosenbloom, 2002; Teece, 2010) defines a product’s value proposition for customers and how the firm will convert that to profit.12 A business model is an organizational and financial architecture which embraces and integrates in a consistent fashion (1) the feature set of the product or service; (2) the benefit (value proposition) to the user from consuming/using the product or service; (3) the market segments to be targeted; (4) the ‘design’ of revenue streams and cost structure; (5) the way products/services are to be combined and offered to the customer; and (6) the mechanisms by which value is to be captured.
Google, the leading Internet search engine, incorporated in 1998, provides clear examples of these business model elements in action. Initially, the company’s investments in proprietary search algorithms and computing resources made it the most popular search engine on the Internet, but these innovations did not translate directly to profits. In late 2000, the company began auctioning ads linked to specific keywords (a system similar to that already employed by a competing search site, GoTo.com). Google recognized that part of its appeal was the minimalist design of its web site, and it has limited ads on the site to simple text. It was Google’s combination of innovation, awareness of how it provided value both to search users and to advertisers, and a system for turning the advertising into revenue—and then into profit—that provided the foundation for the company’s ongoing success.
To seize the opportunities created by innovation, innovators must excel at understanding not only customer needs, but also the possible future evolution of technology, costs, and customer willingness to pay. Even a successful business model, however, is insufficient to assure sustained profitability when imitation is easy. When hard to imitate—or when used to pioneer a winner-take-all market—a business model can be a source of sustained profitability.13
The business model also encompasses a firm’s strategy toward its rivals. Positioning within fast-moving industries often takes the form of a standards competition, either in the market (e.g. Windows versus Mac) or through political maneuvering within a cooperative organization (e.g. the International Organization for Standardization).14 Ownership of a successful standard has numerous potential benefits, including licensing revenue, privileged access to new technologies, and influence over the technology trajectory.
Seizing and transforming capabilities allow firms to refine and expand their business models in order to exploit new opportunities or defend against new competitive threats. They are the means by which organizations remake parts of themselves, possibly redrawing the firm’s boundaries to respond to changes in the business environment. A reformulation of the business model may require radical shifts in the supply chain, asset ownership, or sales channels to ensure continued/improved value capture.
In fast-moving market and technology environments, firms must be ready to continuously reinvent themselves. Netflix is a good example of a firm that went through multiple business models in a short period of time. The initial Netflix business model was based on a pay-per-rental service, but this pricing model was unpopular and the company almost failed. It was clear to management Netflix had to rejig its business model and, between September and October 1999, it relaunched itself with a subscription model. For a fixed monthly fee, subscribers could rent any number of DVDs per month, limited only as to the number held at any one time. The model was supported by a system of regional distribution centers which ensured next day delivery to over 90% of subscribers. The Netflix business model was further refined as management figured out customer preferences and willingness to pay. The company had to adapt again as rental-via-download became a viable option. Since January 2008, Netflix has offered its subscribers unlimited use of the media it has available for streaming over the Internet.
Over the past two decades, our understanding of value capture from innovation and the link to firm strategy has expanded dramatically. A stream of research has stressed the importance of the architecture of the enterprise (especially the boundaries of its ownership and its control of complementary assets) for improving the chances of sustainable success when new technologies are commercialized. The role of supporting institutions and public policy—especially appropriability regimes—has also been highlighted.
This body of work has come to be known as the profiting from innovation (PFI) framework15 and was the topic of a special issue of Research Policy in 2006 (v.35, n.8). PFI addressed a puzzle that had not been well explained in the previous literature, namely: why do highly creative, pioneering firms often fail to capture the economic returns from innovation? The original framework (Teece, 1986) cites several examples (e.g. EMI in CAT scanners, Bowmar in calculators), and the phenomenon does indeed endure. The first-generation PC manufacturers all but disappeared from the scene (and even IBM, which pioneered the Microsoft-Intel PC architecture, exited the business in 2005 by selling its PC business to a Chinese company, Lenovo). Xerox (PARC) and Apple invented the graphical user interface, but Microsoft Windows dominates the PC market with its follow-on graphical user interface. Netscape invented the browser, but Microsoft captured more of the market. Apple’s iPod was not the first MP3 player, but it has a commanding position in the category today. Merck was a pioneer in cholesterol-lowering drugs (Zocor), but Pfizer, a late entrant, secured a superior market position with Lipitor.
At first glance, it is tempting to say that these examples reflect the result of Schumpeterian gales of creative destruction where winners are constantly challenged and overturned by entrants.16 Indeed, entrants with potentially disruptive innovations are almost always waiting in the wings, but many of the cited cases involved mostly incremental/imitative entrants rather than the radical breakthroughs typically invoked in accounts of Schumpeterian competition.
More importantly, there is ample variance in the outcomes from entry, with many cases where first or early movers captured and sustained significant competitive advantage over time. Genentech was a pioneer in using biotechnology to discover and develop drugs, and thirty years later was the second largest biotechnology firm (and the most productive in its use of research and development dollars) right up to its acquisition by Hoffmann-La Roche in 2009. Intel invented the microprocessor and still has a leading market position more than thirty years later. Dell pioneered a new distribution system for PCs and, despite recent challenges and many would-be imitators, remained the leader until it was bypassed by Hewlett-Packard in 2007. Toyota’s much studied ‘Toyota Production System’ has provided the auto maker a source of competitive advantage for decades despite numerous and sustained attempts at imitation, with the company finally becoming the world’s biggest car manufacturer in 2008.
The profiting from innovation framework (Teece, 1986, 2006; Pisano and Teece, 2007) provides an explanation as to why some innovators profit from innovation while others lose out—often to rank imitators—and why it is not inevitable that the pioneers will lose.
The fundamental imperative for profiting from an innovation is that unless the inventor/innovator enjoys strong natural protection against imitation and/or strong intellectual property protection, then the potential future stream of income is at risk. The relevant appropriability regime is thus critical to shaping the possible outcomes.
Appropriability regimes can be ‘weak’ (innovations are difficult to protect because they can be easily codified and legal protection of intellectual property is ineffective) and ‘strong’ (innovations are easy to protect because knowledge about them is tacit and/or they are well protected legally). Regimes differ across fields of endeavor, not just across industries or countries.
The degree to which knowledge about an innovation is tacit or easily codified also affects the ease of imitation, and hence appropriability. The tacitness of knowledge varies to some extent over the product cycle. New products and processes are often highly nuanced. Thus, in the pre-paradigmatic phase of technological innovation (Abernathy and Utterback, 1978; Teece, 1986), the tacit component is likely to be high. Once a dominant design emerges, the rate of change of product design slows, and there is then the opportunity, if not the need, to codify technology. However, more rapid rates of innovation mean that there frequently isn’t time to codify (make explicit) new knowledge even when it is technically feasible to do so.
Patents can in some cases be used to capture returns by slowing imitators and other rivals. However, patents rarely, if ever, confer strong appropriability, outside of special cases such as new drugs, chemical products, and rather simple mechanical inventions (Levin et al., 1987). Many patents can be ‘invented around’ at modest costs (Mansfield et al., 1981; Mansfield, 1985).17 They are especially ineffective at protecting process innovation. Often patents provide little protection because the legal and financial requirements for upholding their validity or for proving their infringement are high, or because, in many countries, law enforcement for intellectual property is weak or non-existent.
The inventor of a core technology can also seek complementary patents on new features and/or manufacturing processes, and possibly on designs. The way the claims in the patent are written also matter. Of course, the more fundamental the invention then the better the chances of a broad patent being granted; and granted in multiple jurisdictions around the world.
While a patent is presumed to be valid in many jurisdictions, validity is never firmly established until a patent has been upheld in court. A patent is merely a passport to another journey down the road to enforcement and possible licensing fees. The best patents are those that are broad in scope, have already been upheld in court, and cover a technology essential to the manufacture and scale of products in high demand.
In some industries, particularly where the innovation is embedded in processes, trade secrets are a viable alternative to patents. Trade secret protection is possible, however, only if a firm can put its product before the public and still keep the underlying technology secret. Many industrial processes, including semiconductor fabrication, are of this kind.
The conundrum that managers confront beyond protecting the innovation itself is at least twofold. First, most innovations require complementary products, technologies, and services to yield value to users. Hardware requires software (and vice versa); operating systems require applications (and vice versa); digital music players require digital music and ways of distributing digital music (and vice versa); mobile phones need mobile phone networks (and vice versa); web browsers and web search engines require web content (and vice versa); airlines require airports (and vice versa). In short, technology must be embedded in a system to yield value to the user/consumer. Value capture becomes more difficult if other entities control required elements of the system.
Secondly, the delivery of product/process innovation requires the employment not just of complements but of many inputs/components up and down the vertical chain of production. Hence, when the inventor/innovator isn’t already in control of the necessary inputs/components, the profitability of the inventor/innovator will be considerably compromised by whatever economic muscle is possessed by owners of required inputs/components. The firm must be prepared to change its assessment over time as the identity of the bottleneck asset may change due to innovation elsewhere in the system.
An obvious implication of this framework is that the firm’s endowment of expert talent (literati and numerati), however brilliant, doesn’t by itself guarantee that the organization will capture much of the value from innovation. Absent quality entrepreneurial managers, good intellectual property protection, and/or some control over complementary assets, superb performances by literati and numerati are likely to be in vain.