388 • Chapter 11 • Sustaining Competitive Advantage

tends to drive down prices. The efficiency effect makes an incumbent monopolist’s incentive to innovate stronger than that of a potential entrant.

In the competition between established firms and potential entrants to develop new innovations, the productivity effect, sunk cost effect, replacement effect, and efficiency effect will operate simultaneously. Which effect dominates depends on the specific conditions of the innovation competition. For example, the replacement and sunk cost effects may dominate if the chance that smaller competitors or potential entrants will develop the innovation is low. Then, the main effect of the innovation for the established firm will be to cannibalize current profits and reduce the value of established resources and organizational capabilities associated with the current technology. By contrast, the efficiency effect may dominate when the monopolist’s failure to develop the innovation means that new entrants almost certainly will. In this case, a key benefit of the innovation to the established firm is to stave off the deterioration of profit that comes from additional competition from firms that may develop a cost or benefit advantage over it if they successfully innovate.

Disruption versus the Resource-Based Theory of the Firm

There are countless examples of industries in which seemingly dominant firms are replaced by newcomers, who, in turn, eventually cede the market to yet another generation of innovators. For example, there was a time when the assets possessed by Wang and Digital Equipment created enormous value and thus generated enormous profits for their shareholders. These assets were eventually supplanted by new assets owned by Intel and Microsoft. Eventually, Apple and Google created a newer set of assets—let’s call them “cloud computing capabilities”—that have begun to supplant Intel and Microsoft. Some might contend that Wang and DEC, and more recently Intel and Microsoft, made strategic blunders by failing to out-innovate their rivals. As the previous suggestion indicates, there is no guarantee that incumbents will win the race to develop disruptive technologies, and it is unfair to say that incumbents have blundered when disruption occurs. This is like saying that Ken Jennings, champion of the television game show Jeopardy, blundered when he lost to Watson the computer.

INNOVATION AND THE MARKET FOR IDEAS

David Teece has observed that a new firm’s ability to prosper from its inventions depends on the presence of a “market for ideas”—a place in which the firm can sell its ideas for full value.24 Teece identifies two elements of the commercialization environment that affect the market for ideas: (1) the technology is not easily expropriated by others, and (2) specialized assets, such as manufacturing or marketing capabilities, must be used in conjunction with the innovative product. The first point is obvious: if a technology is not well protected by patents, the innovator can hardly expect to enjoy significant returns. Consider the fate of Robert Kearns, who invented the intermittent windshield wiper in the early 1960s. He showed the technology to Ford, which rejected a licensing agreement with Kearns, only to introduce its own intermittent wiper soon thereafter. It was not until the 1990s that Kearns was able to uphold his patent in court. An important takeaway is that secrecy is not enough to protect innovators—at some point they must divulge some of their ideas to trading partners. Without good patent protection, they are immediately at risk for expropriation.

390 • Chapter 11 • Sustaining Competitive Advantage

Teece’s second point is more subtle. Innovative products must be produced and marketed. If many firms have the required expertise in production and marketing, they will compete for the rights to the innovation, leaving most of the profits for the innovator. This is yet another example of the ex ante zero profit constraint we have discussed earlier in this chapter and another illustration of rent-seeking behavior that we described in Chapter 7. If the required expertise is scarce, the innovator can no longer sell to the highest bidder. The balance of power shifts away from the innovator and toward the established firm that will produce and market the product. Consider that when Nintendo dominated the video game market, game developers had no choice but to accept Nintendo’s terms for new software. Nintendo no longer commands such power, and software developers such as Blizzard Entertainment and UbiSoft have gained the upper hand in negotiating rights fees.

EVOLUTIONARY ECONOMICS

AND DYNAMIC CAPABILITIES

The theories of innovation we discussed in the previous section are rooted in the tradition of neoclassical microeconomics. In these theories, firms choose the level of innovative activity that maximizes profits. Evolutionary economics, most commonly identified with Richard Nelson and Sidney Winter, offers a perspective on innovative activity that differs from the microeconomic perspective.26 According to evolutionary economics, firms do not directly choose innovative activities to maximize profits. Instead, key decisions concerning innovation result from organizational routines: well-practiced patterns of activity inside the firm. To understand innovation, it is necessary to understand how routines develop and evolve.

A firm’s routines include methods of production, hiring procedures, and policies for determining advertising expenditure. Firms do not change their routines often because getting members of an organization to alter what has worked well in the past is an “unnatural” act. As Schumpeter stressed, however, firms that stick to producing a given set of products in a particular way may not survive. A firm needs to search continuously to improve its routines. The ability of a firm to maintain and adapt the capabilities that are the basis of its competitive advantage is what David Teece, Gary Pisano, and Amy Shuen have referred to as its dynamic capabilities.27 Firms with limited dynamic capabilities fail to nurture and adapt the sources of their advantage over time, and other firms eventually supplant them. Firms with strong dynamic capabilities adapt their resources and capabilities over time and take advantage of new market opportunities to create new sources of competitive advantage.

For several reasons, a firm’s dynamic capabilities are inherently limited. First, learning is typically incremental rather than pathbreaking. That is, when a firm searches to improve its operations, it is nearly impossible for the firm to ignore what it has done in the past, and it is difficult for the firm to conceptualize new routines that are fundamentally different from its old ones. Thus, the search for new sources of competitive advantage is path dependent—it depends on the path the firm has taken in the past to get where it is now. Even small path dependencies can have important competitive consequences. A firm that has developed significant commitments to a particular way of doing business may find it hard to adapt to seemingly minor changes in technology.

The presence of complementary assets—firm-specific assets that are valuable only in connection with a particular product, technology, or way of doing business—can