Strategic Management of Firms Operating in High-Velocity Markets

by Dr Dorel Iosif

LAVAUX

Note:

this is a long paper written for academic purposes. It may take some time to read it in its entirety

1.Idea in Brief

The paper is intended to address the strategic management of firms operating in high velocity markets and in particular the inter-dependencies and trade-offs between ordinary (static) capabilities, causal ambiguity and dynamic capabilities.

Throughout the paper we adopt the resource-based view (RBV) with regard to the link between inimitability and the creation of competitive advantage and Schumpeter’s view of competition as a destructive process in which effort, assets, and fortunes are continuously destroyed by innovation (creative destruction); this view comes in conflict with the neoclassical model of competitive markets which is more suitable to static and monopoly-based markets, hence not the object of this work.

Our work combines some practical perspectives with the theoretical work and should be viewed as an extension of RBV (Penrose, Andrew, Rumelt) and dynamic capabilities (Teece, Pisano) frameworks widely published and taught in academia.

2.Definitions

High-velocity markets

We define high-velocity markets as the locus for a number of sectors that show common similarities, market and capability-wise, in which the cost of information is relatively low while the flow (speed) of information relatively high. This covers all major industries from manufacturing, energy and resources to biotechnology, engineering and pharmaceuticals. An important distinction between static and hi-velocity industries is also the fact that innovations that take place in the far ecosystem arena (“far away” from the firm) can be brought into the firm and its industry with relative ease.

In this sense, the firm operates usually in its “habitable zone” but often the disruption takes place from the periphery inwardly.

Causal ambiguity (CAA)

Throughout the paper, we discuss causal ambiguity (Lippman and Rumelt) as one of the protection mechanisms against imitability. In doing so, we choose to define causal ambiguity as follows:

Causal ambiguity is a firm-level integrated nexus of competencies that result in higher performance and is also difficult to deduce or comprehend externally, even if the Firm is subject to intentional isomorphic pressures from its competitors.

In this definition we postulate that:

• CAA is integrated at the firm’s level (ie. it is a firm level construct) acting as an isolating protective mechanism,

• Isomorphic pressure (if it exists) is mimetic

Inductive-creative reasoning (ICR).

Firms may use ICR (Iosif) as a mechanism for generating strategic scenarios based on “scanning the periphery” of the ecosystem (Teece, Schoemaker, Rowley). ICR combines the specificity of the observation set from the inductive arena and the creativity (and intuition) element from the abductive arena, therefore providing a "cogent" view of the future. This methodology will result in grounded creative thinking and can be used in strategy planning to generate future as-yet unobserved phenomena. While ICR cannot yield an absolutely certain conclusion, similar to inductive reasoning, it is ampliative and can extend human knowledge.

3.Hypotheses

For firms operating in high-velocity markets, we hypothesize the following:

1. Firms’ economic rents are in fact the sum of rents acquired through a series of successive Schumpeterian advantages as a result of innovation. Innovation can occur at product or corporate/business unit level (processes, tangibles, intangibles).

2. Schumpeterian advantages are increasingly becoming “time- thin”, ie the Schumpeterian cycle today is at best 2-3 years and so firms need to innovate more frequently.

3. Once Schumpeterian advantages diffuse they may continue to produce long-lived rents. However, the accumulation of long-lived rents does not ensure firms’ success in terms of competitive advantage (though they may contribute to it indirectly and in the virtue of inertia). Accordingly, firms need to continuously re-innovate to remain relevant.

4. The successive and continuous emergence of Schumpeterian advantages can only exist if firms possess strong dynamic capabilities (Teece) in addition to ordinary capabilities. Creative destruction (Schumpeter) is also necessary. However, possessing strong dynamic capabilities may detract or impair firms’ ability to carry out their current set of activities fully efficiently.

5. Though somewhat static, the Resource-Based View framework (Penrose, Andrew, Collis, Montgomery) does align well with the hypotheses above. Competitive Forces (Porter) and Strategic conflict (Shapiro, Shelling) frameworks do not.

6. Overall dynamic capabilities should be systematically cheaper to build than static (ordinary) capabilities.

7. Causal ambiguity can have various effects on competitive advantage.

8. Strategy is just another form of innovation.

We live in a world of innovation.

Throughout the paper, the acceptance of the word innovation is strictly linked to value creation. This is a given.

Today innovation is seen and felt not only at the product level but in the firm’s supply chain, processes and ability to promote learning and transfer of knowledge. The increasingly global nature of business forces ultimately facilitates innovation providing that firms have the ability to reconfigure and transform in a timely manner. In their work, Teece and Pisano refer to this capability as “dynamic” and disaggregate the nature of such ability into “sensing, seizing and shifting” elements.

In our view, the firms’ capacity to “sense” involves two elements: motivation and infrastructure. By motivation we mean the firm’s concomitant “ability” and “desire”. In order to possess sensing capacity, firms needs to rely on an infrastructure conducive to sensing. This infrastructure resides with:

• the level of entrepreneurship that the leaders possess

• their ability to express and act upon such qualities

• an organizational culture of courageous conversations and

• an organizational setup (org design and processes) that facilitates innovative pursuits

Most firms today reside in high velocity markets. If the firm does not possess sufficient capabilities to protect innovation and create isolation mechanisms, the diffusion of such products, mechanisms, know-how is almost instantaneous.

4.Innovation adopted from outside the firm diffuses at a higher rate

The innovation could be generated not only in the habitable zone but beyond in the ecosystem (see Google driverless car vs GM/Ford). In such cases the firm needs not only to “sense” the opportunity but also to be able to pivot and reconfigure its business or parts of it in order to take full advantage of the opportunity.

Take for instance the biotechnology industry. Even though more than 200 million prescriptions are written annually for cholesterol-lowering drugs, there are some people who still don’t get enough reduction in their LDL.

The discovery of PCSK-9, a protein which inhibited lowers the bad cholesterol by a further 70%, was made outside biotech firms by researchers working not only apart from the prevailing scientific strategy of genome research, but with an almost entirely different approach. This was followed by a flurry of PCSK9 inhibitor based medication, a new class of cholesterol-lowering drugs that are self-injected once or twice a month.

The market potential is enormous. Such are the benefits.

The diffusion of such a discovery was almost instantaneous; Sanofi, Regeneron Novartis and Amgen to name just a few, have all successfully completed medical trials and the drugs are on the market already competing for market share.

Another example is the invention in the late 80’s of numerical-modelling based software. Software companies such as HKS (now part of Dassault Systèmes) and MSC produced suites of such modelling software which were then sold to hi-tech companies worldwide. No attempt was made by HKS or MSC to enter the consulting business; they rather concentrated on adding increasingly sophisticated routines to the software to increase its applicability. A typical “supply-push” type of innovation. Today, virtually every car you drive, plane you fly, bridge you cross or hotel you rest in are designed using numerical modelling based software.

The high applicability of finite element modelling enabled a number of companies to quickly adopt the technology and build short to medium term Schumpeterian advantage. The technology also requires that users possess advanced knowledge in numerical modelling (usually via advanced degrees) hence the diffusion of this technology was slower. However, by mid 90’s the diffusion was complete and the consulting services built around this offering commoditised yielding little competitive advantage.

5.Innovation from within the firm diffuses at a slower rate

In many cases the innovation takes place at the firm level in which case the barriers to imitations can be built more effectively. If the innovation is technological in nature, IP rights and patents can limit to some extent the amount of imitability even if the competition possesses the information related to the new technology; that is simply because possessing information does not automatically means understanding it (Reed, DeFillippi).

Gilead’s hep-C drug Sovaldi came first on the market in Dec. 2013. By March 2014 it provided Gilead with 85% of market share in the hep-C drug sales. Before Sovaldi and Harvoni, the success in hep-C treatment was 50%. Today Harvoni has an almost 100% success rate. When the diffusion of Sovaldi started to take place in Q4 2014, Gilead’s innovation pipeline delivered Harvoni. In so doing, by Q2 2015, the revenue split between Harvoni and Sovaldi reached 80-20, a remarkable transformation for Gilead’s business. IP and patent rights protected Gilead’s continuous development of hep-C pipeline (except in China and India). During this period no other competitor could replicate Gilead’s pace of innovation in hep-C arena. In high-velocity markets the pace of innovation is almost as important as the innovation itself.

When the innovation takes place at process level and contains tacitness and complexity (in other words, a fair amount of causal ambiguity) the simple attempt to imitate it externally is usually futile.

6.The diffusion of innovation

Whether or not the innovation takes place outside the firm or inside the firm, early adopters may (but not necessarily) build a competitive advantage for a short period of time. As the innovation diffuses, if the firm is unable to pivot and re-innovate, the Schumpeterian advantage gained during early adoption disappears. In some extreme cases such firms die if their only core competency was built around an innovation now fully diffused.

Today, the almost complete diffusion of innovation takes place within the first 2-3 years at best. In other words, monetizing based on the competitive advantage gained by innovation (if your firm was the innovator or an early adopter) is at best 1-2 years before it starts becoming asymptotic and then declining into long-lived rents with no bearing on the competitive advantage it generated initially.

We believe that if the innovation takes place at the firm level and causal ambiguities exist and dynamic capabilities are strong, then the competitive advantage generated will last longer than when innovation is brought in from outside the firm.

In order to generate and capitalise on innovation it is important that the firm’s strategy is dynamic.

.A dynamically built strategy emphasizes the importance of strategic step-outs as a methodology for experimenting with new products, processes, business models and where possible, the creation of new markets

The firm may have a demand-pull or supply-push innovation philosophy (Pisano) or a combination of both. When Steve Jobs returned to Apple, he made the switch from a demand-pull philosophy (at that time Apple had 16 computer models) to a supply-push philosophy (one computer model and the thinking behind being “sometimes the customer does not know what he wants”). Locking yourself into one type of approach over another is dangerous but the firm should in theory maintain an open mind.

The strategy as defined by Rumelt should be a coherent mix of policy and action to surmount high stake challenges. The challenges are shaped and in many instances caused by:

• the dynamism of the market,

• the erosion of margins in the game of pushing against the competitive frontier alongside competition

• the long term low price of commodities (if the firm’s habitable zone is natural resources and energy)

• contract renegotiations based on environment changing circumstances

We have shown so far, that surviving in high-velocity markets requires the adoption of some level of dynamic capabilities to manage uncertainty coming from the firm’s immediate habitat or from the fringes of the ecosystem.

Teece differentiates between managing uncertainty and risk; we are in full agreement and shall adopt in this paper his views that managing risk (known unknowns) and uncertainty (unknown unknowns) are separate from each other. Managing (and mitigating against) risk involves mostly the allocation or, at times, reconfiguration of the firm’s ordinary capabilities, the use of natural hedges, risk sharing initiatives, know-how of established financial instruments or contracting it away altogether. Managing uncertainty requires dynamic capabilities: some degree of sensing, developing strategic what-ifs and case scenarios and at times building appropriate “slack” in the business.

Purposely developing dynamic capabilities is difficult as no amount of cost-benefit analysis can predict the outcome in terms of competitive advantage, let alone the impact on the firm’s balance sheet. However, in doing so, the firm acquires the “right” to aspire to remain an industry leader. The “right” does not necessarily ensure success, as it is further a matter of implementation.

7.Competitive advantage. Ordinary and dynamic capabilities and the role of causal ambiguity

In its quest for competitive advantage – the fundamental problem in strategic management – the firm must distinguish between core competencies and distinctive competencies.

The linkage between competitive advantage and competencies (Chamberlin, Selznick) has been made more than 75 years ago and needs no further work.

For simplicity, we define core competencies as the integrated nexus of resources, knowledge and capabilities the firm possesses and deploys in the game of competition within its market.

Part of these core competencies (or all) can become distinctive, that is, they create a competitive advantage in the marketplace. This distinction is important as we believe that in the literature core competencies and distinctive competencies are often used interchangeably.

The functional base of distinctive competencies consists of a set of processes that can display causally ambiguous characteristics that are difficult to comprehend externally even if the firm is subject to intentional isomorphic pressures, mimetic in nature. The more the firm displays distinctive competencies in the marketplace, the higher are the isomorphic pressures exerted by its competitors. If the firm possesses high dynamic capabilities, the distinctive competencies could be linked to firm’s “asset orchestration” ability (Teece, Pisano).

Let us assume further that a fair amount of causal ambiguity exists in the business.

In order to deal with causal ambiguity (CAA) as a whole we disaggregate CAA into external (ie. as experienced by competitors) and internal (ie. as experienced by the firm’s management) so that we can take a position on whether or not causal ambiguity can stimulate, hinder or be neutral to innovation.

If extreme internal CAA prevents management from understanding the internal causal relationships (due to complexity, tacitness or symbiotic specificity) then CAA cannot exist in the first place. We propose then that when extreme internal ambiguities exists, CAA as a whole vanishes because of circular reasoning of the argument (ie. extreme internal ambiguities act as a black hole for the overall CAA). We then postulate that extreme internal CAA is an oxymoron and can not exist.

But we do know that CAA exists (as a whole) and furthermore, this is a source of competitive advantage. It then follows that some internal CAA (albeit not extreme) must also exist in the firm as a result of that. It also follows that the net effect of external minus internal CAA must be always positive for the firm to establish a competitive advantage via the protection against imitation.

We can now proceed and attempt to establish a link between CAA, ordinary capabilities and dynamic capabilities. We believe that CAA is based at large on the complexity and tacitness of ordinary capabilities since it prevents valuable resources from imitation (RBV-VRIN concept). This link is ubiquitous and has been made in the literature numerous times.

But dynamic capabilities can also display CAA characteristics.

Let us assume that irrespective of its organizational design (centralised, de-centralized) the firm has built the ability to adapt to new market shifts by building and reconfiguring its business and in so doing, it claims to have adopted strong dynamic capabilities. In achieving this, the firm possesses now a set of business processes that replaced “best industry practices” and are specific to the firm. A good example is the EPCI energy industry where four Korean companies possess a set of proprietary practices that no other firm has been able to achieve elsewhere outside Korea. As a result, most mega-fabrication projects over the past 10 years have been built in Korea. When the oil price collapsed from its highs in July 2014, these companies, while highly unionised, were able to pivot and adapt to a new price regime ahead of every other competitor and maintain their competitive advantage. In this particular case, a fair amount of CAA exists throughout the business and inherent to internal dynamic capabilities. These firms displayed highly evolutionary characteristics which of course are dynamic in nature.

We believe that irrespective of the CAA locus in the business, it would be difficult for a firm to display a high level of CAA in their static competencies as well as in dynamic competencies due to the prohibitive cost involved in running such a business.

At this juncture, firms should decide on the trade-offs that they need to make in order for the two type of competencies (ordinary and dynamic) to co-exist and co-evolve.

8.Change or you will be changed. Conclusions

To paraphrase H.E Sheikh Mohammed bin Rashid Al Maktoum “Change or you will be changed”. In high-velocity markets the environment is ruthlessly dynamic. This requires a matching strategy, a strategy that promotes innovation generation and implementation as the fundamental law of the firm. We claim that that firms operating in high-velocity markets, need to continuously innovate to remain relevant since the Schumpeterian advantage cycles are time-thin.

It is why the strategy of the firms should clearly roll-out routines conducive to innovation. Such routines may come in conflict with others based around static capabilities but both need to co-exist and co-evolve. In this respect, at the firm level, strategy in itself has the characteristics of innovation:

• it conveys a sense of corporate advantage,

• displays compatibility with the business

• holds enough complexity

• must be observable to everyone in the business (clear line of sight)

• ensures alignment with ever-changing business environment and markets, and

• creates economic value for the customers (which value is captured by the firm)

In other words, for firms operating in high velocity markets, strategy is just another form of innovation at the process level. Strategy needs to be cogent and compelling.

If the firm is a startup or younger, the ability to discover, search, scan and experiment – all dynamic traits – is higher than in a mature large scale firm. A younger firm (or a start-up) can experiment with acquiring resources that sometimes fail to generate unique value proposition to the business, simply because the firm is quickly able to discard them.

For a mature business, experimentation is more costly and “scanning the periphery” is rare. Mature firms operating in high-velocity markets are often forced to choose between surviving today’s challenges (usually by operational effectiveness) and strategic positioning for tomorrow’s profits. As a CEO, the choice seems to be complex when, in reality, it is quite simple: CEO’s should be concerned with the firm’s ability to innovate and create frequent sets of short-lived competitive advantages. Operational effectiveness (OE) is a given but the combustion engine or Gilead’s Harvoni didn’t surface as a result of OE or six sigma. To facilitate the construct of innovation in the firm’s strategy, leadership matters. For innovative firms, leadership is a source of differentiation.

Firms should weigh in the trade-offs between competencies required to “keep the lights on” and those required to create new and frequent competitive advantages (resulting in Schumpeterian rents) via innovation. These trade-offs are not easy to arbitrate upon and should clearly be identified and percolate through the strategy process that firms undertake.

Acknowledgments

The author would like to thanks Prof. David Collis (Harvard Business School) and Chris Zook (Bain & Co) for their contributions and commentary.

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