Presented at Wharton School Virtual Strategic Management Seminar

1. Evolutionary Economics,
Routines, and Dynamic
Capabilities
David J. Teece
UC Berkeley Haas School of Business
for the Wharton School Virtual Strategic Management Seminar
March 4, 2021

2. Evolutionary Economics & Dynamic Capabilities
Both Seek to Fashion a Theory of the Firm
Winter (2000) defines an organizational capability as:
a high-level routine (or collection of routines) that, together
with its implementing input flows, confers upon an
organization’s management a set of decision options for
producing significant outputs of a particular type.
• Applies to “ordinary” capabilities: the everyday jobs that
companies perform repeatedly to generate the goods and
services currently required
• Ignores “dynamic” capabilities: higher-level routines and
decisions that add and subtract ordinary capabilities to ensure
that output will align with (or shape) the market environment
going forward.

3. Shared Ancestry
Evolutionary Economics and Dynamic Capabilities (Teece, Pisano, and
Shuen, 1997) both draw on
• Behavioral theory (bounded rationality, search, adaptation)
• Austrian economics (discovery, shifting opportunities, creative
destruction, disequilibrium)
But the organizational change envisioned in dynamic capabilities is
• purposeful rather than random (evolution with design)
• revolutionary, not evolutionary
3

4. (Dynamic) Capabilities Definitions Have Yet to Fully Converge
Winter (2003/2011) Eisenhardt & Martin (2000) Helfat et al. (2007) Teece (2014-2018)
Basic
Level
“zero order” or “zero level” - the 'how we
earn a living now' capabilities: producing
and selling the same product, on the same
scale and to the same customer population
(2003, p.992)
“operational” – enables the firm to
perform ongoing tasks for making a
living (p.5)
“ordinary capabilities” -
administrative, operational, and
governance-related functions that
are necessary to the execution of
current plans (2016, p.204)
Intermediate
Level
“first order” – enables a firm to alter how it
currently makes its living. Examples: new
product development or the opening of new
outlets. The definition implies “reliable
patterned behavior.” (Helfat & Winter, 2011,
pp.1244-5)
“dynamic capabilities” - organizational and
strategic routines by which managers
acquire and shed resources, integrate them
together, and recombine them to generate
new value-creating strategies to match and
even create market change. Examples:
product development, TMT decision making,
replication, resource allocation, coevolving,
patching, knowledge creation, alliance
formation, M&A (pp.1107-8)
“dynamic capabilities” – the
capacity of an organization to
purposefully create, extend, or
modify its resource base. The
function must be repeatable and can
be reliably executed. (p.4)
“low-level DCs” or
“microfoundations” - processes
for forming external partnerships
or for developing new products.
They consist of (often
idiosyncratic) routines that are
employed less often than the
routines of ordinary capabilities.
Microfoundations allow the firm to
integrate, reconfigure, add, or
subtract resources (2018, p.364).
High
Level
“higher order” - investments in
organizational learning to facilitate the
creation and modification of dynamic
capabilities for the management of
acquisitions or alliances (2003, p.994)
“dynamic managerial capabilities” -
the capacity of managers to create,
extend, or modify the resource base;
can also change the external
environment (p.3)
“dynamic capabilities” - enable an
enterprise to profitably build and
renew resources and assets that
lie both within and beyond its
boundaries, reconfiguring them as
needed to innovate and respond
to (or bring about) changes in the
market and business environment
(2014, p.332)
4

5. Routines Are at the Heart of the Evolutionary
Economics Approach
• Routines ...
... are how the firm’s day-to-day business gets done
... economize on bounded rationality
... evolve through learning
• Learning ...
... occurs through repetition, problem solving, and mutation/selection
... is a local phenomenon; radical change is rare
• For practitioners, infatuation with routines ...
... favors efficiency over effectiveness
... can blind managers to remote search for the next big thing
... will crimp dynamic capabilities
5

6. Over-reliance on Routines Limits the Role of
Entrepreneurial Managers in a Theory of the Firm
• Teece (2012, 2014): dynamic capabilities encompass both
organizational routines and non-routine managerial action.
• Winter (2003): “ad hoc problem solving” and “dynamic capabilities”
are “different ways to change.”
• Winter (2017)
• “System 1” (automatic routines) and “System 2” (deliberative decisions) are
both necessary for change”
• “I would [argue] for tuning the System 1 emphasis up a little and System 2
down a little, relative to Teece”
• Teece (today): Not sure yet whether to take Sid’s advice. It’s worth a
debate.
6

7. Routine-Based Ordinary Capabilities
• Maintain the firm on its current trajectory
• Are strengthened by achieving best practices
• Best practices subject to copying by rivals through consultants, etc.
• Only a few companies need to achieve best practice to undermine them as a
source of competitive advantage
• In certain cases, an ordinary capability can evolve in such a unique
way that it becomes a hard-to-copy “signature” capability
• Rare case where ordinary capabilities contribute to sustainable competitive
advantage
• Ex: Toyota Production System stood out for decades; Detroit eventually
achieved similar result through different routines
7

8. Dynamic Capabilities
• Govern the firm’s ability to change to deal with deep uncertainty in the
business environment
• Reside mainly in the characteristics of the top management team
• Integration of the top management team is vital
• The organization’s values, culture, and collective ability to quickly
implement a new business model or other changes are also integral to the
strength or weakness of the firm’s dynamic capabilities
• Must be established well in advance of being needed
• Combine high-order routines with managerial decisions
• Both ”lower-order” and “high-order” dynamic capabilities can be identified
8

9. Lower-Order Dynamic Capabilities
• Lower-order dynamic capabilities enable the firm to repeatedly
perform certain strategic activities such as M&A, entering new
geographic markets, and new product development
• Like all dynamic capabilities, these augment, subtract, or reconfigure
resources
• They may be supported by signature routines that enable smooth execution
and maintain organizational alignment
• Simple Rules (Eisenhardt) can aid the strategic decision making
• Not a routine; a strategic guideline (e.g., don’t merge with larger firm)
• Guardrails to manage complexity
9

10. High-Order Dynamic Capabilities
• There are no guardrails for these future-focused decisions
• “No Rules Rules” (Reed Hastings)
• “Reason from first principles” (Elon Musk)
• Key strategic decisions decisions are non-routine (e.g., “how can we
disrupt an adjacent market?”)
• Top management team may employ “signature processes” arising from
company heritage, context-specific learning
• Building a resilient, flexible organization in advance of needing one is
critical
10

11. Steve Jobs: Innovation at Apple is a blend of
flexibility and discipline
“. . . there is no system. That doesn’t mean we don’t have process... we have great
processes. But that’s not what it’s about. Process makes you more efficient. But
innovation comes from people meeting up in the hallways or calling each other at
10:30 at night with a new idea, or because they realized something that shoots
holes in how we’ve been thinking about a problem. It’s ad hoc meetings of six
people called by someone who thinks he has figured out the coolest new thing ever
and who wants to know what other people think of his idea. And it comes from
saying no to 1,000 things to make sure we don’t get on the wrong track or try to do
too much.”
11
Cited in Burrows, 2004

12. Differing Perspectives on Change
• Evolutionary economics tends to think of change being driven by
technological innovation
• Dynamic capabilities sees change as multi-dimensional
• Technology
• Business Models
• Markets
• Identifying the requirements of change in a multi-dimensional space
identifies which capabilities and resources need to be adjusted,
added, or replaced
12

13. Example of Multi-dimensional Change
13
Source: Teece (2019)

14. The Entrepreneur is Absent From Evolutionary
Economics
• Nelson and Winter (1982) noted that “the entrepreneurial function”
is absent from mainstream economic theory
• They didn’t develop the idea further
• Schumpeter: “Carrying out a new plan and acting according to a
customary one are as different as making a road and walking on it.”
• Winter: there is an “essential continuity between these instances of
dramatic innovation and the smallest sort of adaptation to changing
conditions”
• Entrepreneurship is finding new combinations to forge a new path.
IT IS NOT (EVOLUTIONARY) ADAPTATION; IT IS A STEP CHANGE.
14

15. How Elon Musk Approaches Key Decisions
• “You have to build up the reasoning from the ground up—from the
first principles”
• “then you see if you have a conclusion that works or doesn’t work,
and it may or may not be different from what people have done in
the past”
• After Musk reasons out his goals for a project and a strategy, he tests
them continually, and adjusts them regularly based on what he learns.
• A “cook” follows recipes. A “chef” builds new ones from raw
ingredients, experience, and personal taste.
from T. Urban (2015) “The cook and the chef: Musk’s secret sauce”
15

16. Dynamic Capabilities Can Reduce Path Dependence
• A clean slate approach to big challenges means that existing routines
(or their absence) need not constrain the decision space.
• Rather than partner with an existing auto maker, Musk built Tesla’s
ordinary capabilities from a blend of Japanese-style continuous
improvement with Silicon Valley culture
• The goal: envision the future, then build an organization to align with
it
• Retain what fits; replace or supplement what doesn’t
16

17. Dynamic Capabilities
• Three main categories of activity
• Sensing: Developing and testing a model of the future
• Seizing: Implementing new business models derived from
tested conjectures
• Transforming: Keeping the organization aligned with evolving
strategies
• Sensing, Seizing, and Transforming should be ongoing and
embedded throughout the organization
17
See Teece, 2007

18. Not All Decisions Are Strategic
• Jeff Bezos:
• “Some decisions are consequential and irreversible or nearly irreversible –
one-way doors – and these decisions must be made with great deliberation
and consultation ... Call these Type 1 decisions”
• “Most decisions are two-way doors. If you’ve made a suboptimal Type 2
decision, you don’t have to live with the consequences that long. Type 2
decisions can and should be made quickly by high judgment individuals or
small groups.”
• “As organizations get larger, there seems to be a tendency to use the heavy-
weight Type 1 decision-making process on most decisions, including many
Type 2 decisions. The end result of this is slowness, unthoughtful risk aversion,
and diminished invention.”
J. Bezos, 2015 Letter to Shareholders.
18

19. Entrepreneurial Management Underlies Dynamic
Capabilities
• Characteristics of successful entrepreneurs include tenacity, strong
self-confidence, optimism, a tolerance for stress, and a willingness to
work long hours.
• Entrepreneurial characteristics are hard to teach
• Inside organizations, “entrepreneurial managers” (Teece, 2007, 2016)
combine entrepreneurship with the leadership needed for strategy
implementation.
• Entrepreneurial thinking should be part of the organizational culture.
19

20. The Three Functions of Managers
Operational Entrepreneurial Leadership
Responsibilities
Planning and
Budgeting
Sensing and Seizing
Propagating Vision
and Values
Activities
Organizing and
Staffing
Orchestrating
Resources
Aligning People with
Strategy
Levers
Control and Problem
Solving
Investing in R&D,
Developing New
Business Models
Motivating People
Goals
Technical Efficiency
and Predictable
Results
Competitive
Advantage
Unity of Purpose
20
Teece, 2016
The top management team
must be strong in its
entrepreneurial and
leadership functions for the
organization to have strong
dynamic capabilities.

21. Not all Managers Are Entrepreneurial
• Great operational managers add value and differentiation, too
• Tim Cook famously built Apple’s best-in-class supply chain capabilities
• Entrepreneurial management combines creativity, logical rigor, high
risk tolerance, and people skills
• Not all entrepreneurial managers are of the same quality
• Poor managers can hold the firm back instead of propelling it forward
(Rosenbloom, 2000)
21

22. Strategy in the Dynamic Capabilities Framework
Political, economic, social institutions
Generic
Resources
Human capital Distinct
Resources
Ordinary Capabilities
(Operations,
Administration,
Governance)
Strategy
Dynamic
Capabilities
Level of
Profits
22

23. Top Management Requires Ambidexterity, an Important
Component of Dynamic Capabilities
• Multiple entrepreneurial efforts across an organization must be
protected from rivalry for resources by established businesses
• Getting this wrong has produced some major missed opportunities
• IBM botched the PC revolution
• Microsoft botched Internet infrastructure software
• “the incumbent firms had no difficulty building the raw organizational
capabilities necessary to compete in the new markets” yet both were tripped
up by “very considerable organizational conflict” between the new business
and the old (Bresnahan, Greenstein, and Henderson, 2011)
• Ambidexterity is part of dynamic capabilities (O’Reilly and Tushman, 2008)
• It’s a form of “asset orchestration,” which is part of “Seizing”
23

24. Differing Perspectives on Strategy
• Dynamic capabilities support strategy; strategy shapes capabilities
• A good strategy (Rumelt, 2011) generally involves
• diagnosis (problem definition and analysis)
• a guiding policy (general approach adopted), and
• a coherent plan for actions to be taken
• Evolutionary approach sees strategy as bottom up (Noda and Bower,
1996); middle managers generate ideas that compete
• Doesn’t fit Musk and Tesla; might fit Jobs and Apple where organizational
capabilities are more mature
• Dynamic capabilities approach sees strategy as top-down; middle
managers translate and implement strategy
24

25. A Modest Proposal:
Dynamic Capabilities as a Workable Systems Theory
• In the strategic management realm, evolutionary economics should be
viewed as a component of the dynamic capabilities framework
• Evolutionary economics complements a broader range of phenomena,
particularly non-routine entrepreneurial acts
• Entrepreneurs like Henry Ford, Thomas Edison, Charles Merrill, Sam
Walton, Walt Disney, Bill Gates, Steve Jobs, and Elon Musk transformed
industries by pursuing a singular vision with unusual skill.
• Entrepreneurial acts (e.g., creating new markets) drive economic growth
and change
• Working together, evolutionary economists and scholars interested in
capabilities can craft a capabilities theory of the firm
25

26. References
Bezos, J. (2016). Amazon Letter to Shareholders, 2015. Available at https://drive.google.com/file/d/0BzVmPBUYS4gaVE9Cc2tualVLMjA/view
Burrows, P. (2004). The seed of Apple’s innovation. businessweek.com (12 October). Available at https://www.bloomberg.com/news/articles/2004-10-11/the-seed-of-apples-innovation.
Eisenhardt, K. M., & Martin, J. A. (2000). Dynamic capabilities: what are they?. Strategic Management Journal, 21(10‐11), 1105-1121.
Helfat, C. E., Finkelstein, S., Mitchell, W., Peteraf, M., Singh, H., Teece, D., & Winter, S. G. (2007). Dynamic capabilities: Understanding strategic change in organizations. John Wiley & Sons.
Helfat, C. E., & Winter, S. G. (2011). Untangling dynamic and operational capabilities: Strategy for the (n)ever‐changing world. Strategic Management Journal, 32(11), 1243-1250.
Nelson, R. R., & Winter, S. G. (1982). An Evolutionary Theory of Economic Change. Cambridge, MA: Belknap Press.
Noda, T., & Bower, J. L. (1996). Strategy making as iterated processes of resource allocation. Strategic Management Journal, 17(S1), 159-192.
O’Reilly, C. A., & Tushman, M. L. (2008). Ambidexterity as a dynamic capability: resolving the innovator’s dilemma. Research in Organizational Behavior, 28, 185–206.
Rosenbloom, R. S. (2000). Leadership, capabilities, and technological change: The transformation of NCR in the electronic era. Strategic Management Journal, 21(10‐11), 1083-1103.
Rumelt, R. (2011). Good Strategy/Bad Strategy: The Difference and Why It Matters. New York: Crown Business.
Teece, D. J. (2007). Explicating dynamic capabilities: the nature and microfoundations of (sustainable) enterprise performance. Strategic Management Journal, 28(13), 1319-1350.
Teece, D. J. (2012). Dynamic capabilities: Routines vs entrepreneurial action. Journal of Management Studies, 49(8), 1395-1401.
Teece, D. J. (2014). The foundations of enterprise performance: Dynamic and ordinary capabilities in an (economic) theory of firms. Academy of Management Perspectives, 28(4), 328-352.
Teece, D. J. (2016). Dynamic capabilities and entrepreneurial management in large organizations: Toward a theory of the (entrepreneurial) firm. European Economic Review, 86, 202-216.
Teece, D. J. (2018). Dynamic capabilities as (workable) management systems theory. Journal of Management & Organization, 24(3), 359-368.
Teece, D. J. (2019). A capability theory of the firm: an economics and (strategic) management perspective. New Zealand Economic Papers, 53(1), 1-43.
Teece, D. J., Pisano, G., & Shuen, A. (1997). Dynamic capabilities and strategic management. Strategic Management Journal, 18(7), 509-533.
Urban, T. (2015). The cook and the chef: Musk’s secret sauce. Blog dated November 6, 2015. https://waitbutwhy.com/2015/11/the-cook-and-the-chef-musks-secret-sauce.html#13.
Winter, S. G. (2000). The satisficing principle in capability learning. Strategic Management Journal, 21(10‐11), 981-996.
Winter, S. G. (2003). Understanding dynamic capabilities. Strategic Management Journal, 24(10), 991-995.
Winter, S. G. (2017). Pursuing the evolutionary agenda in economics and management research. Cambridge Journal of economics, 41(3), 721-747.
26