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Chapter 3: Micro Foundations of Firm’s Advantage – Dynamic Capabilities View

In a previous chapter, we learnt about resource-based view (RBV), knowledge-based view (KBV) and core competence view (CCV) hypotheses. A major limitation of these hypotheses is that they are not designed for the VUCA world – the world that is volatile, uncertain, complex and ambiguous. Therefore, they do not consider the entropy factors – the factors that act as disruptive forces in highly dynamic markets. In this chapter, we will examine three of the most important entry factors:

• mainstreaming of non-consumers, i.e. the rise of new groups of customers served using alternative sets of resources, knowledge and/or core competencies.

• political power play, i.e. the role of non-market – often government-supported - factors in enabling competing firms to develop alternative sets of resources, knowledge and/or core competencies.

• globalization games, i.e. the shifts in the advantages of different national markets, and as a consequence of the firms having investments in those markets.

Micro foundations of firm’s advantage refer to the structures, processes and behaviors that help firms navigate the VUCA world. Development of appropriate structures, processes and behaviors that are in tune with the VUCA world allows firms to be dynamic in their capability. Dynamic capability is the capability for recognizing and responding or adapting to significant market change. Dynamic capability view (DCV) hypothesis of strategic action is intended to help firms stay relevant and is of strategic advantage for larger corporates and their stakeholders.

In this chapter, we will also learn about different types of marketplaces, and how to classify these marketplaces using the niche density (number of firms in a marketplace) and carrying capacity (size of the market) approaches. It is important to recognize the link between the concept of dynamic capability and the type of marketplaces. By operating in different types of marketplaces across different business divisions or regional geographies, the firms may be able to gain experience and develop structures, processes, and behaviors to not only survive but also thrive in a VUCA world.

Exhibit 3.x illustrates the evolution of DCV, based on the refinements of RBV, KBV and CCV. KBV distinguishes capabilities (and knowledge-base of the capabilities) from resources. CCV distinguishes core competencies (creative integration and innovative combination of knowledge) from ordinary capabilities (articulation and replication of knowledge). DCV distinguishes transforming capabilities, from core competencies.

Exhibit 3.x: Refinements in RBV, KBV and CCV Bring DCV in Perspective

Entropy Mechanisms under Dynamic Environments

We need a significant revision in the original elitist assumptions of the RBV, KBV and CCV, to account for the success of firms in face of the environmental crisis and dynamism in the 21st century. RBV, KBV and CCV were all based on a linear, functional approach, emphasizing acquisition and possession of resources, knowledge and core competencies. RBV, KBV and CCV held that if elitist firms developed increasingly higher-order resources, knowledge, and core competencies through innovative combinations and creative integrations, they will be able to stay relevant with a competitive advantage on a sustainable basis. Central and common to all these three views is a strong belief in the isolating mechanism assumption – that complex resources, knowledge, and core competencies are difficult to substitute and imitate, therefore giving rise to firm heterogeneity, above-average returns and a competitive market share.

To motivate the need for the alternatives to RBV, KBV and CCV, we will use the concept of entropy. In thermodynamics, entropy is a measure of disorder or information deficit in a system; valuable knowledge declines in closed systems, reaching a point when the system lacks any usable valuable knowledge. By focusing almost exclusively on factors internal to a firm, RBV, KBV and CCV inherently imply rapid entropy or loss of valuable useful knowledge of an elitist firm in dynamic environments. In the chaotic, crisis-driven, and catastrophe-aware world of the 21st century, the limitations of these static and elitist perspectives have become evident. The ability of many emerging market firms to successfully compete with large elitist MNEs has further precipitated a need for other alternative, and more inclusive, internal firm-based perspectives on strategic advantage.

Let’s identify three major factors contributing to entropy in dynamic environments, and label them as “eroding mechanisms”. As illustrated in Exhibit 3.x, eroding mechanisms counter the isolating mechanisms, and have powerful influence on the ability of the firms to sustain their strategic advantage.

Exhibit 3.x: Entropy Counters RBV, KBV and CCV in Dynamic Environments

Non-consumer Mainstreaming: Research on innovation shows that new entrants often succeed using alternative sets of resources, knowledge and core competencies to address the needs of those presently not consuming a product, being underserved and/or overlooked. Christensen’s (1997) work Innovator’s dilemma finds most dramatic innovations occur when firms strive to design products addressing the needs of those who are not currently consuming a product. Christensen shows that in a number of industries, firms who introduced such innovations for non-consumers eventually gnawed into the advantage of firms who were focused on former consumers. Examples include the small off-road motorcycles introduced by Honda in the 1960s, Apple's first personal computer, and Intuit's QuickBooks accounting software. Though they seemed to be niche products initially, eventually they all created massive growth.

Entropy-effects of non-consumer mainstreaming have increased in the industrial markets, as firms have shifted their focus from empowering and sustaining innovations, to efficiency innovations (Christensen, 2013). The income inequity level has risen sharply worldwide, with nearly 80% of the world population – residing primarily in Africa and South and Southeast Asia – earning less than $2 / day. With increased globalization, there is an inter-firm rivalry jostling for capturing the left out 80% consumers.

Empowering innovations translates into transforming complex and costly products into simpler, cheaper, and redesigned products for a wider range of consumers. In the computer industry for example, there have been several waves of empowering innovations, which have expanded the consumer base from governments (mainframes, priced at $100,000+), to businesses (desktops), to urban consumers (laptops), and to even rural users (tablets – such as the $40 Akash tablet designed by the scientists in India and the US). Exhibit 3.x tells the story of Sony, once a pioneer in empowering innovations, who later became entrapped when even more empowering innovation became possible.

Exhibit 3.x: Sony – An Empowering Innovator Gets Entrapped

Source: Adapted from Christensen & Raynor (2003)

Sustaining innovations improve the performance of established products and services along the dimensions that customers in major markets are willing to pay a premium for. They contemporize products to be in sync with the needs, aspirations and lifestyle of today’s consumers for which they have much greater interest and willingness to pay. Examples include microprocessors enabling personal computers to operate faster; and battery enabling laptops operate longer. Overall with globalization, the number of firms pursuing sustaining innovations has increased; whereas, the ability of all firms to make meaningful sustained innovations, without undue cost increases, on a continuing basis has decreased drastically.

‘Efficiency’ innovations improve the cost-effectiveness of existing products, so that the consumers get greater value for their money with even superior quality. These are the types of innovations that many emerging market firms like Patanjali Ayurveda are following very successfully, to cater to the left out 80% market. Other examples of efficiency innovations include organizational innovations such as just-in-time manufacturing, online insurance underwriting by GEICO, and technological innovations such as the mini-steel. Exhibit 2x highlights the case of ministeel and dramatic efficiency innovations, that allowed greater mass access for cars and other steel-intensive products.

Exhibit 3.x: Ministeel as a disruptive efficiency as well as sustaining innovation

Political powerplay: Non-market factors, including governments and other social actors, play an important role in enabling competing firms to develop alternative sets of resources, knowledge, and core competencies. Let’s consider three types of political powerplays – predatory, regulatory, and reputation. At times firms experience predatory powerplay, i.e. regulators may be blindsighted by rivals who lower prices and assume losses for a temporary period in order to capture customers and vendors, away from existing firms. Conversely, regulators might impose very high taxes, liability and insurance costs, or audit and reporting requirements, thereby making an existing firm’s operations financially unviable. Finally, reputation erosion occurs as established firms become a target of reputation powerplay. Here, the consumers may choose to boycott large successful firms who are highly visible to various stakeholders and media, as they seek to push corporates to align more with their values of conscious capitalism, including green environment, human rights, and reasonable profits.

Globalization Games: We identify three types of globalization games that may erode the advantage of established firms:

Development Games – governments in emerging markets may support the development of their firms using a variety of means - e.g. they may compel foreign firms to transfer intellectual properties with limited compensation, and/or they may be lax on issues of human and environmental rights. They may also use public investments for acquiring raw materials from around the world and then offer them to their domestic firms at below market costs; and/or, they may manipulate their exchange rates if they are an export-driven economy. As a matter of fact, the Chinese government is known for aggressively pursuing all these means. Thus, when governments focus on these development efforts for specific sectors with large emerging markets, firms in other nations may suffer rapid erosion of their strategic advantage.

Trade Games –governments in industrial markets may promote industries that are capital and technology intensive as these require specialized skills, offer scope for improving productivity in their nations, and sustain well-paying jobs both in production and service offerings. They may use state-funded enterprises and defense initiatives for the initial development of the industry, offer fiscal incentives, R&D and training subsidies, and state partnership to their domestic firms. For instance, the Canadians supported aircraft development through state-run Canadair, supported Technology Partnerships Canada (a form of R&D assistance), Export Development Canada, and military contracts for maintenance and training. Similarly, many governments in Europe came together to promote and support Airbus in order to create a viable European aircraft alternative to Boeing of the USA. Boeing had to lobby hard with the US government in order to regulate and contain the European government support for airbus, and to sustain its strategic advantage.

Industry Games – in a global environment, every national region looks to offer different types of strategic advantages to the domestic firms, because of their industry base, education and skill base, innovation initiatives, and investments involving enhancement of productivity of the local workforce including places where an affordable cost of living allows labor costs to be dramatically low. Due to this, global production and service patterns are subject to rapid change; and these changing patterns in turn offer new opportunities for trade and exchange, enabling even new or less known firms to dramatically improve the cost-effectiveness, design, and value of their products over the established firms.

The Dynamic Capability View under Dynamic Environments

With a greater understanding of the risks of entropy mechanisms, there has been a huge interest in developing new intrinsic perspectives of strategic advantage that are sensitive to environmental dynamism. One of the most important of these perspectives is the Dynamic Capability View (DCV), which is an outgrowth of the previous research on resources, knowledge, and core competencies (Teece, Pisano & Shuen, 1997). The purpose of DCV is to explain how competencies are transformed over time so as to provide innovative responses to market changes (Helfat et al, 2007), and also focus on how firms invest in, trade, and exchange their resource and knowledge base, so as to maximize organizational fit with the environment at large. The term ‘dynamic’ connotes agility, speed, and timeliness in addressing the changing external market conditions (Teece, Pisano & Shuen, 1997).

Baretto (2010: 171) offers the following definition of dynamic capability based on his synthesis of the literature: “A dynamic capability is the firm’s potential to systematically solve problems, formed by its propensity to sense opportunities and threats, to make timely and market-oriented decisions, and to change its resource base.”

We discuss below three major perspectives on DCV: the process perspective, the structural perspective, and the behavioral perspective.

The Process perspective of DCV has its origins in the scholarly work of Cyert and March (1963), who presented the sense-making process within a firm emphasizing how certain codes are more or less likely to be learnt by a firm according to whether or not they generate positive consequences under conditions of external shocks. This outcome-based sense-making process helps a firm adapt to its environment and build its adaptive capability.

A major factor in the challenge for sense-making process is the amount of disruptive change experienced in a market (Collis, 1994). Based on the amount of disruptive change, the sense making process requires different types of dynamic capabilities, as illustrated in Exhibit 3.x.

Exhibit 3.x: The Process Perspective of DCV

Classification of Dynamic Capabilities

Organizational outcomes

-Enhanced strategic advantage

• First-order change and improvement (or operational) capabilities: In less dynamic environments, the pace of change is slow and the extent of change is also limited. These changes call for continuous, micro adjustments and improvements in a firm’s resources and how they are deployed (Ambrosini, Bowman & Collier, 2009).

• Second-order change and reconfiguration (or renewing) capabilities: Instead of simply seeking to improve existing resources, knowledge and core competence, they focus on evaluating whether the organization is performing the right activities (Teece, 2007). They contribute to new business development, by reconfiguring the resources, knowledge and core competencies of a firm. For instance, Virgins’ reconfiguration capabilities helped it to apply its core competence in brand value into new domains, including airlines, mobile phones, cosmetics, bridal wear, cola, railways. Sony’s reconfiguration capabilities helped it apply its core competence in miniaturization into new domains, including radio, hi-fi, computers and personal navigation.

• Third-order change and reconstruction (or regenerative) capabilities: This may require firms to creatively destroy their resource endowments and portfolios, reconstruct an entirely new form and to move into an entirely new market space. For instance, after the World War II, McDonald’s destroyed its earlier and successful full-service car hop restaurant, and built the fast food format. People then thought that the founder-owners of McDonald’s have gone insane, but McDonald brothers were convinced that in the post-war era, people were seeking the thrill of everything on the go. Ray Kroc, a multi-mixer salesman, became so enamored by the success of the sole McDonald restaurant in San Bernardino city, California that he decided to first license the McDonald format in 1954, and then bought the global rights on that format in 1961 for $3.7 million in cash (equivalent to $16.2 million in 2013).

Exhibit 3.x illustrates the case of GlaxoSmithKline, which embarked upon building dynamic capabilities after its industry experienced a significant crisis.

Exhibit 3.x: Reconstruction Capabilities in the Pharmaceuticals Industry

The Structural perspective of DCV emphasizes the role of social and organizational structures in guiding the knowledge management processes, especially for supporting higher-order dynamic capability (Zollo & Winter, 2002; Macher & Mowery, 2009). Social and organizational structures include technological paradigm, ecological context, and organizational design.

New technology structures may foster higher-order dynamic capability. For instance, in an interesting study, Barley (1986) demonstrated that the introduction of medical imaging devices, such as the CT scanner, challenged traditional role relations among radiologists and radiological technologists, and this changing social structure spurred changes in organizational processes, depending on the individual-level factors.

Similarly, new ecological structures, such as new space and institutions, may foster higher-order dynamic capability. For instance, open offices and competitive conditions facilitate open administration and organic interaction, while closed offices with regulated institutional conditions may perpetuate a bureaucratic logic with rigid administrative structures and processes over time (Baron et al, 1996).

Finally, organizational design (e.g. tall vs. flat, functional vs. multidivisional, matrix vs. network) also impacts the development of higher-order dynamic capability (Felin et al, 2012). For instance, a multi-divisional organization design might give rise to gaps in shared knowledge about different functional competencies across parts of the organization, and, in turn, compromise integration, innovation and change (Hoopes and Postrel, 1999). Inter-organizational structures are also important. Using data on acquisitions in the banking industry, Zollo & Singh (2004) found that the dedicated organizational structures for improving the process of codification of acquisition-specific knowledge contributed to post-acquisition performance. Similarly, using data on alliances among the US-based firms, Kale & Singh (2007) found that the dedicated organizational structures for improving the process of alliance learning contributed to firm-level alliance success.

Exhibit 3.x illustrates the structural view of DCV, and shows how it complements the process view of DCV.

Exhibit 3.x: The Structural View of DCV and its complementary with the Process View

The behavioral perspective of DCV

The concept of corporate-level dynamic capability faces the challenge of reconciling human agency (i.e. freedom of people to make choices), with the tendency of all collectivities to suffer from inertia. The human agency provides this new energy, by directly influencing the development and operation of organizational and social processes and structures. Human agency that shapes corporate-level dynamic capability may be set among all members (e.g. in fully decentralized organizations), or led by a few influential formal or informal leaders (e.g. senior executives or decision-makers).

In practice, individuals demonstrate varying degrees of agency (i.e. true freedom of choice). When the degree of agency is low, individuals may act in a passive, fast, automatic, habitual or regularized fashion. The degree of agency tends be low when the members involved have limited amount of resources, knowledge, and skills to cope with change, such as in highly turbulent situations. Thus, the behavioral perspective regarding human agency complements the process and structure perspectives on the development of dynamic capability.

Exhibit 3.x portrays two alternative models of how behavioral factors may interact with the structural and process factors of DCV and contribute to organizational outcomes. In model 1, structures guide processes to shape behaviors for effective decision-making. In model 2, behaviors shape structures, which in turn moderate how behaviors shape processes that generate organizational outcomes.

Exhibit 3.x: Behavioral Factors Interact with the Structural and Process Factors of DCV

Model 1: Structures Guide Processes to Shape Behaviors for Effective Decision Making

Model 2: Behaviors Guide Processes, moderated by Structures, for Effective Decision Making

The behavioral perspective expands the focus of DCV from the ‘doing” aspect, to the “deciding” aspect (Helfat et al, 2007: 115). This ‘deciding’ aspect is a function of cognitive, emotive, and social/ relational factors, as discussed below.

Cognitive factors and Organizational decision-making

Strategic decision-making involves cognitive factors such as planning, attention, and problem solving. Leaders seeking to promote a distributed model of strategic decision-making may shape enabling organizational processes and structures by asking questions such as: How to sensitize planning to opportunities emerging in the distant horizon? How to filter critical issues for attention? How to afford requisite support to members for their problem solving strategies?

Eesley and Roberts (2009) find that leaders and change agents who bring experiences with a broader set of responsibilities and functions allow firms to build more valuable and cognitive representations of market opportunities. However, under conditions of highly novel technology and rapidly changing industry, over-reliance on the prior experience of key executives can have negative effects (Eesley and Roberts, 2010). Under these conditions, it is important that the organizational processes and structures also support forward-looking cognitive efforts, such as envisioning novel scenarios and discovering innovative options as part of the problem-solving behaviors (Gavetti and Levinthal, 2000). But the flip side points to firms or individuals who rest on previous laurels, thereby tending to rely more on historical path-dependencies (Laamanen and Wallin, 2009); this in turn orients individuals and firms more towards reaffirming and reproducing existing resources and routines, as opposed to spurring new sets of activities for driving change. Therefore, as alluded by model 2 of behavioral factors above, corporate-wide organizational structures that trigger early warnings and sensitize members about the seriousness of the actual or impeding crisis may be helpful in breaking historical path-dependencies (Felin et. al., 2012).

Firms may also be able to design structures to guide process that in turn shape behaviors (model 1 above). Corbett & Neck (2010) identify three types of organizational attributes through which corporate executives may help shape cognitive or mental maps for the decision-making processes and enable major innovative breakthroughs. These organizational attributes are structures and processes related to

(1) the ‘arrangements’ an organization needs to make or secure to bring about changes in the organizational processes

(2) the ‘willingness’ to change current organizational practices

(3) the ‘ability’ to execute change in organizational practices.

Arrangements structures and processes include culture, coaching, and top management support. To elaborate, an entrepreneurship-supportive culture encourages experimentation and thereby accepts minimal losses. Coaching is important for members when they have limited experience with a novel technology or market. Top management support is compulsory to protect members from being a scapegoat while working on innovative efforts. Without this ‘vital’ support from the top management, innovative efforts are often found wanting, lack continuity and focus.

Willingness structures and processes address issues such as career conflicts. Research shows that many individuals are unwilling to take international postings, because of a fear that this will take them away from the top managers at their home-base and exclude them from future advancement opportunities. Under these situations, willingness structures and processes guide individuals to pursue those opportunities, and stay committed to them (Mitchell et al., 2000).

Ability structures and processes enhance the abilities and build confidence. An example of such abilities is bricolage, defined as ‘making do by applying combinations of the resources at hand to new problems and opportunities’ (Baker and Nelson, 2005: 333); that bricolage relies on scavenging various resources so as to extract usefulness from resources that others do not value or do not intend to use. Therefore, it banks on experimentation or improvisation and in doing so, breaks down or reconfigures resource combinations. Individuals and firms who target bricolage for addressing particular issues (selective bricolage) are more likely to be successful.

Corbett and Neck (2010) conclude that firms with great entrepreneurial ability tend to show a greater cognitive balance with emphasis on all three types of mental maps (arrangements, willingness and ability) and thereby enjoy better dynamic capability. In contrast, firms showing cognitive imbalance tend to experience lower dynamic capability and eventually lose out on the strategic advantage with new initiatives.

Emotive Factors and Organizational Decision-making

Strategic decision-making also involves emotive factors, i.e. moods and motives. Cognitive psychology based on neuro-scientific evidence shows that in practice, cognitions work interactively as well as conjointly with emotions in regulating thought and behavior (Duncan & Barrett, 2007). Emotions may manifest as either transient moods (e.g. fear, anger) generating temporary change in mental states, or intense motives or drives (e.g. pride, envy) generating a more sustained modification in mental states. As mood and/or motives are activated, a change in behavior is triggered; this could either be deliberate involving new strategic decisions rooted in a systematic evaluation of the stimuli; or could be ‘adhoc’, such as involving a routinized emergent choice response, based on a general sense or gut feeling about the nature of the stimuli and its potential impacts. Exhibit 3.x portrays this emotion-based organizational decision-making.

Exhibit 3.x: A model of emotion-based organizational decision-making

Emotion-based ability has generated a considerable interest among scholars of human behavior. Known also as emotional intelligence, it refers to an individual’s ability to recognize and regulate one’s emotions, so that desired decisions that are taken are in the best interests of all parties concerned (Salovey & Mayer, 1990).

Huy (2012) identifies the need for organizations to develop their own emotional capability comprising of the ability to recognize, monitor, discriminate, and attend to emotions of employees at both individual and collective levels. His organizational emotional capability theory posits that “organizations that develop procedures related to emotion management and that provide systematic training on this subject to various managers likely reduce the need to rely on the innate competence of individuals’ emotional intelligence.”

The role of emotional intelligence and organizational knowledge structures (i.e. emotional capability) in enhancing emotion-based organizational decision-making for enhanced strategic advantage, and in the process developing dynamic capability in the form of improved knowledge structures, is illustrated in Exhibit 3.x

Exhibit 3.x: A model of developing emotion-based dynamic capability

Knowledge structures

Emotional intelligence

Dynamic Capability

Examples of organizational events eliciting strong emotions among large groups include any radical change, be it in the organizational identity, change in the executive leadership team, mergers and acquisitions, strategic alliances or joint ventures, and/or outsourcing and downsizing. Different sub-groups within the organization experience different emotional responses to any such event, and may have multiple ways to deal with their emotions (Huy, 2012). For instance, when key executives leave after a hostile takeover by another company, for some it may be beneficial in terms of individual growth, while for others it may be malefic due to the individual connect that they possibly had with those employees.

Huy (2012) studied a large technology firm, where top executives emphasized structure and process perspectives of DCV. The study showed that strategy implementation faced significant group-focus emotional issues related to the social identities of the middle managers, such as newcomers vs. veterans, and English- vs. French- speaking. These group-focused emotions led middle managers to support or covertly undermine a particular strategic initiative, even when their immediate personal interests were not impacted.

Relational factors and Organizational decision-making

Finally, relational factors also play a significant role in strategic decision-making. In dynamic markets, individuals often lack the capacity and capability to enact the full range of competences necessary to make and execute effective organizational decisions. They must seek complementary resources, knowledge, and skills via their social network of relationships, both within the firm, as well as outside the firm such as consultants or alliance partners (Jones et al, 2011; Dyer & Singh, 1998).

Scholars emphasize the need for the organizations to develop their social capital, a term connoting cognitive and emotive connections (e.g. “goodwill, fellowship, sympathy among individuals and families) with key groups (Hanifan, 1920). Blomqvist & Seppänen (2003) observe that in dynamic markets, people must learn how to establish, manage, and dissolve relationships, while also maintaining a good reputation as a potential partner in the market. The capability to build trust, to collaborate and to simultaneously manage them becomes critical for effective decision-making under uncertain and crisis-laden situations. Social networks are important because friendship and kinship ties can provide access to resources at less than market price (Starr and Macmillan, 1990), or even provide resources that are simply not available via market transactions (Baker, Miner & Eesley, 2003). Networks strongly shape the trajectory of a firm because they allow people to bootstrap resources, knowledge and insights, when such assets are not available to them directly based on their own historical paths of experiences, and thus improve the dynamic capability of the firms to respond more effectively to crises or new opportunities (Jones, Macpherson & Jayawarna, 2011). An additional benefit of social relationships in the contemporary knowledge economy is its potential to generate large amount of data, referred to as “Big Data”. Companies such as Google and Facebook are essentially Big Data businesses, whose staggering market valuation and profitability steps from analyzing data about those connected to their products, and applying that to advertising.

In dynamic markets, high levels of solidarity, i.e. strong long-term exclusive relationships within a small group, can be counterproductive as well (Portes and Landolt, 1996). Burt’s (2005) research demonstrates that optimal network value is created by structural holes, i.e. by brokering connections between segments that would be otherwise unconnected. High levels of solidarity with a small group is referred to as within-group or bonding social capital, as opposed to “weak ties” for strategic and need-based exchange of resources, knowledge and insights, which are referred to as across-group or bridging social capital (Woolcock, 1998). Therefore, in dynamic markets, bridging social capital based on weak ties have been found to be more effective in giving individuals flexibility of innovative action and access to new, creative knowledge structures that are more pertinent for dealing with change.

Dynamic Capabilities and Firm Performance

Having discussed the process, structural, and behavioral perspectives on the development of dynamic capabilities, an obvious follow-up question is how dynamic capabilities are related with organizational performance outcomes. There are three schools of thought in this regard.

The first school contends a direct effect of (stronger) dynamic capabilities on performance outcomes such as competitive advantage (Teece et al., 1997; Zollo & Winter, 2002).

The second school contends an indirect effect, whereby the firm’s resource-base mediates the influence of dynamic capabilities on performance outcomes (Protogerou et al., 2011). Thus, Ambrosini, Bowman & Collier (2009) suggest a two-step process through which dynamic capabilities influence a firm’s performance. In the first step, dynamic capabilities contribute to the development of resources, knowledge and core competencies, and in the second step, these resources, knowledge and core competencies contribute to a firm’s performance.

The third school contends an interaction of both direct and indirect effect, emphasizing these direct effects represent influence on organizational decision-making (Eisenhardt & Martin, 2000; Helfat et al., 2007). Schilke (2014) used a sample of R&D alliances to show that the alliance learning (interpreted as dynamic capability) influences firm’s performance mostly indirectly, i.e. by increasing the firm’s alliance management capability (interpreted as an ordinary knowledge asset). However, the alliance learning also had a direct positive impact on firm’s performance, indicating that the dynamic capabilities also enable ad-hoc problem-solving decision-making strategies in addition to building knowledge assets (Schilke, 2014). Further, dynamic capabilities may also shape the direct influence of knowledge assets on a firm’s performance. In fact, sometimes this influence can be negative – for instance, when dynamic capabilities generate undue or disproportionate disruption in existing knowledge assets (Schilke, 2014).

The relationship between dynamic capabilities and firm performance is moderated by three major contingency factors, including market dynamics, organizational attributes, and human agency. As previously observed, market dynamics influence whether a firm’s knowledge assets generate sufficient functional energy to offset entropy pressures, and are able to assure and sustain strategic advantage. Drnevich & Kriauciunas (2011) find that market dynamism negatively impacts the contribution of ordinary knowledge assets and positively impacts the contribution of dynamic capabilities to firm performance. Similarly, organizational attributes, such as strategic intent, history, scale and scope may also influence how organizational decisions for continuity or change are translated into newknowledge assets. Baretto (2010) underlines how strategic commitment to significant future market growth might provide an impetuous to dynamic capability development. Finally, human agency or freedom may accept the processes, structures, and behaviors triggered by past developments of dynamic capability, or may reject or modify that.

Exhibit 3.x portrays the influence of the three contingency factors in the relationship between dynamic capability and firm performance. The exhibit includes not only the feedforward relationship between dynamic capabilities and firm performance, but also how firm performance generates a feedback loop, triggering executives to re-evaluate processes, structures and behaviors undergirding current dynamic capabilities. This re-evaluation process in turn triggers organizational decisions for strategic and/or adhoc developments in their knowledge assets, which include resources, knowledge, and core competencies/ insights.

Exhibit 3.x: A Contingency model of Dynamic Capability and Firm Performance

Human agency dynamics

Organizational attributes dynamics

Market dynamics

Dynamic Capability Development Trigger

Marketplace Characteristics and How to Develop Dynamic Capability

Marketplace characteristics is an important factor in the behavior of the firms. When firms operate in multiple marketplaces that have differing characteristics, that can be a powerful way to develop dynamic capability. The behavior of participants in a marketplace depends on the characteristics of the marketplace in which they operate. As shown in Exhibit 6.5, there are two typologies of market structures – one based on the niche density (i.e. the number of competitors), and the other based on carrying capacity (i.e. the industry lifecycle). In economic theory, four major types of traditional markets are identified based on the number of competitors: (1) Monopoly (single firm), (2) Oligopoly (a few firms), (3) Monopolistic competition or niche markets (many firms), and (4) Perfect competition (numerous firms). Another important structural characteristic is the industry lifecycle. In strategy literature, four types of markets are identified based on the industry lifecycle: nascent markets, hyper-competition, dominant firm, and fragmented market. Each of these market structures offers differing constraints, opportunities and incentives to the firms. Therefore, each market structure encourages distinctive types of behavioral capability, and when the firms operate across different market structures, they could develop higher-order change capabilities.

Exhibit 6.5: Typologies of Market Structures

Market Structures based on Niche Density, and Strategic Behaviors

Monopoly: Monopoly refers to a market structure with only one firm. The monopoly firm is largely free to decide its own price, output, and other product and service features. However, if the monopolist overtly restricts the output, over-prices its products, and fails to offer high quality services, then it faces a risk of new firms entering the market and trying to cater to the market segment left unsatisfied by the monopolist. Traditionally, monopolistic firms are viewed in a bad light – they tend to be complacent, bureaucratic, inefficient, not very innovative, loathsome to new entrants, and lastly keep their prices exorbitantly with poor service quality. The basic assumption on which a monopolistic firm conducts its business is that it will be able to profit from its exclusive position in the market just by preventing new competition. With the profits being huge at the onset, it induces other firms to try and replicate the same, even if other rivals exist. Historically, several large firms have been known to act in this manner, such as Microsoft using its domination in the personal computer industry in the 1990s to drive out Netscape, once a leader in the web navigation market. Alternatively, if all other rivals of a large firm are roughly equal to its size and are few in numbers, the players may seek to collude and coordinate their actions. OPEC for example – the association of the oil and petroleum exporting countries – has been known to act in this behavior striving to keep the oil prices high.

Monopolists are known to engage in a range of tactics, or games, to impede the entry and success of other entrants. One such game is “predatory pricing”, wherein the firm charges a price below its costs with the intent to drive out other entrants. Another game is “essential facility denial”, wherein the firm denies the use of essential facilities, such as refrigerated freezers given by an ice-cream company to the retail outlets, to other entrants. “Vaporware” is the third game, wherein the firm makes fake announcements intended to stop customers from switching to a better product of other entrants. Governments try to check the negative behaviors of monopolists using anti-trust and fair competition laws.

As discussed in Exhibit 6.6, in the Internet era, new types of monopolies – referred to as creative monopolies – have emerged, which are actually helping to cut the monopoly power of suppliers, and transfer value back to the consumers. A great example is Amazon, which in 2014 in the US alone held a 67% share in the e-book market, a 41% share in the new books market, and a 15% share in the total e-commerce market. Since then it has strengthened its eBook market position by introducing a highly successful eBook reader. It has used its monopoly power in the eBook market to create a business model where it asks all publishers to make the new eBooks available to the consumers for $9.99. It advocates sharing 30% of this value with itself, and the rest being split equally between the authors and the publishers. Amazon flexed its monopoly power muscles in this case as it noticed that legacy publishers are increasingly becoming like irrelevant middlemen whose presence in reality is keeping book production costs unreasonably high; therefore it offers an option to the authors to publish directly with it. On the other hand, the traditional publishers hated this approach, as it undercut their ability to sustain their profitable business models. As a counter response, many major publishers colluded with Apple to force a model on eBook sellers where the publisher sets the prices for books and retailers simply take a commission. They also tried hard lobbying with the government to introduce regulations to break Amazon’s monopoly on eBook distribution. However, in 2012, the Justice Department found the major book publishers at fault for colluding to prevent the creative entrepreneurship of Amazon.

Oligopoly: Oligopoly comprises of a few large firms that perceive one another as mutually inter-dependent. Success requires firms to consider the effects of their actions on the competitors’ behavior. There is an intense rivalry along several dimensions, such as price, quality, brand image, and market share. The actions of one firm influence the performance of other firms, and require counter-actions from the rivals if they wish to neutralize or balance the competitive effects on their performance. Rival firms seek to better understand the capabilities of the competitor’s along with their strategic priorities in order to better anticipate the behavior, and thereby focusing on those specific actions that would prevent detrimental responses and generating added value instead. Some actions such as upgrading the product or service quality and/or reducing the cost using technological breakthroughs that yield first-mover advantage are difficult to replicate quickly and cost-effectively – unless firms anticipate and plan for the actions of their rivals. Therefore, competitive games in an oligopoly become highly interactive.

According to Porter (1985) a firm in an oligopoly often faces a dilemma. It can pursue the interests of the industry as a whole and avoid price based competition, or it can behave in its own self-interest at the risk of sparking retaliation and escalating industry competition to a battle. Thereby, it is best for a firm to strike a balance between industry level cooperation (to avoid profit eroding warfare) and firm level competition (to avoid giving up potential revenues and profits). One way for the firms to do so is to merge with or acquire their rivals. In fact, Lynn (2011) mentions in his book, “Cornered,” showing the rising concentration and consolidation of nearly every American industry since the 1980s. Dominance by two or three firms “is not the exception in the United States, but increasingly the rule.” For example, while drugstores seem to offer unlimited choices in toothpaste, just two firms, Procter & Gamble and Colgate-Palmolive, control more than eighty per cent of the market share. Six movie studios receive almost 87% of American film revenues. Four wireless providers (AT&T Mobility, Verizon Wireless, T-Mobile, Sprint Nextel) control about 89% of the cellular telephone service market. In many industries, all the oligopoly firms collectively engage in the practice of “parallel exclusion,” i.e. efforts to keep out new entrants. In the 1980s and 1990s, established airlines like American and United kept the startup rivals out through their collective control of the landing ‘slots’ at major airports. Until they were stopped by the antitrust rules, Visa and MasterCard created parallel exclusionary policies trying to prevent the new entrant American Express from succeeding in the credit-card industry, including blacklisting banks that sought to deal with American Express.

Others hold that oligopolistic markets may encourage fierce competition among firms, allowing consumers to benefit from low prices and high production. The carbonated soft drink industry, for instance, has long been dominated by two giants - Coca-Cola since 1886 and Pepsi Cola since 1899. They sell cola drinks with similar taste and color, and controlled 70% of the market in 2012 – with Coke at 42% and Pepsi at 28% (Walston, 2014). Both have the most advanced technology for lower costs and have well-managed distribution channels, suppliers and bottlers. They exclude new entrants by keeping prices low, so that the entry is not profitable for the new entrants. They consider the reaction of each other closely, and when one reduces its price, the other follows to avoid customers switching. Knowing that the other will match price-based competition, they strive to compete on factors other than price. They invest in extensive advertising to differentiate on positioning: Coke represents happiness and moments of joy, while it protects culture and maintains the status quo. Pepsi is associated with capturing the excitement of life now, for youth who are energetic, fun loving and daring. Both firms also invest in research and development to advance their competitive advantage. Coke has about 500 brands, including Coke, Diet Coke, Fanta, Sprite, Dasani, and Powerade. Although it leads Pepsi in most market segments, Pepsi has been quite successful in developing new segments.

Overall new evidence suggests that most oligopolistic markets tend to become ineffective, and ripe for creative destruction by new firms. This is elaborated in Exhibit 6.7.

Niche Markets: consist of market segments within the larger marketplace that emphasize a particular need, or geographic, demographic or product segment but that differ along some key dimensions from other market segments in the marketplace (Teplensky et al., 1993). Nichemanship is a method of carving out a small part of the market whose needs are not fulfilled, and matching these unique needs by specializing along market, customer, product, or marketing mix lines (Shani and Chalasani, 1992). This allows each competing firm to dominate their market niche; therefore such market structures are also referred to as “monopolistic competition.” For instance, in the food market, there are several alternative niche markets, such as organics, local products, heritage varieties, biodynamics, and humanely treated livestock. To develop and sustain competitive advantage in its niche market segment, each firm invests into co-specialized set of complementary assets, including brand name, human capital, vendor relationships, and organizational culture. These assets allow firms to take actions that do not materially affect competing firms, thereby mitigating the risks of customers switching to the firms in other segments. Niche markets require firms to support their niches through continuous value differentiation. Repeated, targeted actions allow the firms to stretch their core competencies to enter into the niches occupied by their rivals. Similarly, shifts in technology and demand open opportunities in new niches. For instance, the organic food market niche is sub-divided into two niches: one where customers purchase organic food for environmental reasons and the other where customers purchase organic food for nutritional reasons.

Firms have two options for value differentiation in niche markets. The first option, ‘vertical differentiation’, involves adding high performance or quality features to the complementary assets. As shown in Exhibit 6.8, vertical differentiation strategies can be displayed using a cost quality frontier. In the Indian hotel market for example, the Taj Group – a five star hotel chain – is perceived by everybody to be higher in quality and has a higher cost structure. In contrast, Comfort Inn is a budget hotel, and is perceived by everybody to be lower in quality and has thereby a lower cost structure; whereas, Clark Hotels lies somewhere in between as a budget option.

The second option, ‘horizontal differentiation’, involves creating a distinctive niche by discovering a unique way of combining and applying a common set of complementary assets, and/or by appealing to a distinct customer group. As shown in Exhibit 6.8, horizontal differentiation strategies can be displayed using a circular mapping. Consider a city that has three equally well-stocked grocery stores. The consumers tend to prefer the one that is closest to their home, and thus consumers vary in their preferences about the grocery store.

Exhibit 6.8 Horizontally and Vertically Differentiated Niche Markets

From a strategy perspective, niche markets are attractive when they have the following characteristics (Cuthbert, 2011: 4):

1. The niche is of sufficient size and has the purchasing power to be profitable.

2. The niche has growth potential.

3. The competitors have put low priority or attention to that niche.

4. The firm has the required skills and resources to exploit the niche.

5. The customers in the niche have a distinct set of needs.

6. The customers prefer the firm that best satisfies their needs.

7. The firm gains certain economies through specialization.

8. The firm is able to defend its niche by constructing some barriers to entry.

Consider the case of Household Insecticides sector in India, in Exhibit 6.9. Godrej has identified several niches in this Household Insecticide market, to capture an overall 50% share across categories during the 2000s:

A key success factor in the niche markets is the establishment of close relationships with customers. An effective strategy is usually based on the principles of differentiation and customer service. Niche markets offer an opportunity to firms having limited resources to establish a more stable long term market position through relationship marketing, and the development and maintenance of barriers to entry through product, organizational and market innovations. Parrish (2003), studying large firms in the textile business, found that these firms developed niche domestic markets as a means of competing against multinational lower cost producers. Exhibit 6.10 illustrates the strategies for identifying opportunities and competing in a niche market.

Perfect Competition: is characterized by the lack of significant fixed costs or investments, and running business largely on variable costs. Firms tightly monitor their variable costs, and compete on efficiency. A most efficient use of the resources – in particular the labor and effort of the entrepreneur implies that the firms that use their labor less productively are forced to exit the competitive game. The firms do not invest in developing new technologies in-house or in expensive outside technologies – instead they rely on affordable and accessible technology. This allows newer firms to enter and survive, with limited barriers to entry. A perfectly competitive industry is analogous to a fish market near a fishpond open for public fishing, where any person may catch and sell fish. With free entry, new firms find it easy to set up shop and start producing and selling. These firms also have the flexibility to shut shop at any time without making any losses. This often invites fly-by-night players to make a fast, extra buck by free riding on the public goods and social infrastructure. Such predatory economic conditions often challenge the ethics and the sense of social and ecological responsibility of the players. Though the basic economic theory considers perfect competition to be the ideal state for social welfare, it does not provide effective conditions for the growth of the firms or the industry. Exhibit 6.11 illustrates the challenge of a perfectly competitive market, and the need for regulating this market to ensure at least some level of commitment from the firms to build trust and success.

The costs of government regulation must eventually be borne by each of the players. Post the Enron corporate scandal for instance, the US government imposed several stringent regulations on financial and accounting firms in the US, which severely limited their flexibility to service the competitive needs of clients, and had added to their costs of due diligence and monitoring the transactions.

The utility of the perfect competition market is greater as a standard for promoting healthy competition. A major insight from this concept is that when the access to infrastructure, technology and knowledge is based on the pay per use model, then more firms are likely to enter the market with limited risks of huge losses if they fail. Such pay per use model can bring about several creative endeavors and promote innovation and growth. eBay and Amazon marketplaces are one of the closest examples of perfectly competitive markets. They allow any seller to offer their product without investing significantly in the fixed costs of technology or inventory. Yet, for success and growth on these marketplaces, individual sellers need to build a history of positive reviews, trust and reputation, which in turn enables them to charge a premium and have an edge as compared to their rivals that lack such history.

Market Structures based on Industry lifecycle and Strategic Behaviors

Based on the carrying capacity or industry lifecycle, market structures may be classified as nascent (emerging cycle), hypercompetitive (growth cycle), dominant (maturity cycle), and fragmented (decline cycle).

Nascent Competition Market: are usually spurred by technological innovation, newly emerging customer needs, along with economic and sociological shifts. A distinguishing characteristic of the nascent competition market is the lack of any “rules of the game.” These markets are characterized by a competitive race among the firms to establish their own technologies, and to create a dominant market paradigm centered at the use of their technologies by all the players. The firms tend to make huge upfront investments for rapidly commercializing their technologies. It is however, difficult for most firms to make profits as technological, operational and other logistics are not fully functional. This in turn jeopardizes the entire cycle involving, vendors, stakeholders, customers and investors alike. Thus, for a new entrant tasting success would mandate it to right on top on several fronts: improved technology, forging advantageous relationships with channel partners, acquiring a core group of loyal customers, accessing patient venture capitalists and entrepreneurial human capital A firm first to introduce a commercial technology, gains a lead, and might develop a “first mover advantage”. However, a failure to cement the early lead may cede the window of opportunity to the competitors. Exhibit 6.12 illustrates the vast opportunities for the nascent commercial drone industry, made possible because of rapid advancements in technology and reduction in component costs.

Hyper-competitive market: it is turbulent and fast changing where the rules of game are continually shifting, spurred by the processes of globalization and information economy. It is characterized by shrinking product life cycles, growing demand for mass customization and individualized personalization of products and services, increasing complexity of organizational architecture, and intensifying pressures for controlling process costs while sharing more value with the strategic vendors, channel partners, knowledge workforce, and institutional investors. In contrast to the nascent competition markets, huge upfront firm-specific investments may not be sufficient and can even be counter-productive if the firm is unable to recoup the costs within a short period, given the high turbulence and velocity of the market. Firms therefore seek to distribute up-front investment requirements, either across a network of firms or over time. On the one hand, they collaborate with key reliable participants in the game to reduce risks and to pool capabilities; on the other, they phase investments over time for an early and timely achievement of key competitive milestones, such as generating a positive cash flow. A strategic priority is needed on developing a learning organization that continuously discovers, generates, and applies knowledge for added value in subsequent milestones, including additional product development and market commercialization.

A firm competing on the edge of hyper-competition thrives on the “guerilla advantage,” referring to skills, experiences, and competencies to rapidly and repeatedly forming new sneak competitive advantages based on different rules and resource combinations than the existing strategies being used, and in the process keeping the competitors on their toes. It does not necessarily imply reinventing the wheel, rather making it better. In a hyper-competitive market, it enables the firms to generate “increasing returns” from their organizational learning, because of a focus on the constant discovery of new ways to apply technological endowments for added value. Consider the case of Domino’s Pizza in the USA in Exhibit 6.13:

Without appropriate collaborations and/or without a long-term strategy, firms find it difficult to succeed in hypercompetitive markets, as illustrated by the case of Radioshack in Exhibit 6.14.

Illustrating Nascent competition vs. Hyper-competition: Exhibit 6.15 shows that firms may be able to gain and sustain their first mover advantage for a substantial period during the nascent competition stage. However, once several new entrants enter, and the market becomes hyper-competitive, firms need to continuously identify new sources of advantage to create and sustain their performance.

Exhibit 6.15: Nascent vs. Hyper-competitive Markets

Dominant Firm: A dominant firm’s structure comprises of a single large firm at the core, and several smaller firms at the periphery of the market. The dominant firm functions as the market leader or the focal point for fixing prices, and defines the basic benchmarks for input costs, product value, and service quality. The dominant firm generally enjoys a competitive advantage based on lower costs deriving from an early entry and “learning-by-doing”, large economies of scale, and proprietary technology; but it may also offer a better product, especially for customers seeking a low cost standardized offering. Smaller firms focus on niches that are not profitable or attractive for the dominant firm, due to factors such as smaller scale, idiosyncratic resources and knowledge bases, and customized services of the smaller firms in their target markets.

The dominant firm may partner with the smaller firms, such as by making them its subcontractors in areas where they can offer lower costs and/or greater variety-on-demand. However, the smaller firms may be concerned about the power of the dominant firm, or may not be able to scale up to meet the needs of the dominant firm. Some of the smaller firms may be very successful in growing their niches, and may be willing to be acquired by the dominant firm in order to achieve more rapid expansion. But, if the market is relatively mature and saturated, then the growth of smaller firms may hurt the dominant firm, increasing their motivation to either keep out or acquire smaller rivals. However, if the smaller firms open new segments, the dominant firm may not retaliate. For instance, consider the German steel industry Pre-World War II in Exhibit 6.16.

A dominant firm generally poses significant policy and social responsibility questions for business strategy. One of the major issues is whether a dominant firm has the legal, ethical or social responsibility to collaborate and support smaller firms and their innovations or innovative potential, and/or whether it is appropriate for it to learn from the innovative smaller firms and render them unviable. Manishen (2014) observes,

“Could Uber be required as an antitrust matter to open its system to Hailo drivers? Is Twitter liable to TwitPic for integrating its own photo-posting function into the 140-character tweet service, thus effectively putting some third-party companies out of business? Are Microsoft, or Google, or Apple required to open their APIs to competitors or, once opened, legally prevent them from reverting to a closed ecosystem?”

A special form of the dominant firm is the vertical dominance, where a dominant firm forms captive vertical relationships with vendors and distributors. Vertical dominance is often motivated by a desire to promote mutual investments, and learning among the partners. Exhibit 6.17 illustrates the pros and cons of vertical dominance by Toyota and its suppliers, referred to as Keiretsu, in the face of global competition.

Fragmented: a fragmented structure is one in which no firm has a significant market share for influencing the market outcomes. The name of the game in here is “local responsiveness, wherein repeat, local customers form the majority or often the totality of business. While the products tend to be expensive and not very well developed, the success depends on keeping the costs low using a “bare bones” approach with low overheads, minimum wage employees, and tight cost control. The prices are forced down by limited demand; in fact just enough so that the firm can cover its overheads, stay afloat, and generate some earnings for the owner-managers of the firms to live. The budgets for product development, market promotion, information technology, and employee training tend to be non-existent or very limited.

A fragmented structure often arises when the government breaks-up a monopoly, or deregulates entry into an erstwhile monopoly market. The telecom sector in the US for example became highly fragmented after breaking up AT&T and deregulation of entry of other players. Similarly, the broadcasting business in India became fragmented after the government allowed private entrants into a sector monopolized earlier by Doordarshan.

Mergers and acquisitions is a dominant approach for consolidating a fragmented market. Another way of connecting the fragmented markets is through codification and franchising of the business formula: food and motel chains, for instance, offer standardized, efficient, low-cost “formula” facilities at multiple locations. Finally, verticalization – developing deep relationships with channel partners, customers and the vendors – can also allow the firms to restructure the local, fragmented markets, and to align with the globalizing marketspace. Many of the fragmented structures are currently being transformed into vertically networked and horizontally consolidated global operations. The use of information technology for supply chain management, quality assurance, and customer relationship enrichment is a major force underpinning success in this new competitive game, as illustrated in Exhibit 6.18.

Conclusions

In this chapter, we learnt about the entropy factors that make firm’s existing resources, capabilities, and core competencies irrelevant. In order to prepare themselves for the entropy factors, the firms need to develop dynamic capability. That requires firms to invest in appropriate structures, processes and behaviors. It is not easy to make these investments, because the firms existing resources, capabilities and core competencies do not prepare them for the VUCA world that may be entirely unanticipated and different. One effective tactics to foster the experience and the environment where alternative structures, processes and behaviors thrive in an organization is to understand the different types of market structures a firm may operate in. The firm may find these different types of market structures in different business divisions and/or in different regional geographies. Awareness and mastery of how to operate effectively across these multimarket scenarios, will help firms develop dynamic structures, processes, and behaviors to not only survive but also thrive in the VUCA world.

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