Strategizing, Disequilibrium, and Profit 9781503625525

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STRATEGIZING , DISEQUILIBRI UM, AND PROFIT

STRATEGIZING, DISEQUILIBRIUM , AND PROFIT

John A. Mathews STANFORD BUSINESS BOOKS An Imprint of Stanford University Press

Stanford University Press Stanford, California

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Mathews, John A. (.John Alwyn) Strategizing, disequilibrium, and profit/ John A. Mathews. p. em. Includes bibliographical references and index. ISBN 0-8047-5254-0 (cloth: alk. paper)ISBN 0-8047-5483-7 (pbk.: alk. paper) 1. Strategic planning. 2. Equilibrium (Economics). 4. Profit. 5. Entrepreneurship. I. Title. HD30.28JvB742 2006 338.6'048-dc22

3. Competition.

2005031348

Original Printing 2006 Last figure below indicates year of this printing: 15

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Typeset by TechBooks in I 0/13.5

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Contents

Acknowledgments List of abbreviations List of Figures

vii ix xi

Introduction Capitalism Is Not and Never Can Be a Stationary System

15

Entrepreneurial Profits Can Only Be Earned in Disequilibrium

46

4

Rents versus Profits as Strategizing Goals

59

5

Strategizing Is Carried Out by Penrosean, Resource-Based Firms

73

6

No Firm Is an Island: Strategizing in Networks

98

7

The Economy as a Whole: Strategizing Linked to Entrepreneurial, Industrial, and Evolutionary Dynamics

120

Strategizing in Disequilibrium: Dynamic versus Comparative Static Frameworks

152

Toward a Unified Theory of Management

167

2

3

8

9

vi

Contents

Appendix 1

Appendix

2

Entrepreneurship and Economics: A Case of Shocking Neglect Strategy and the Theory of Profit

181 185

Notes

189

References

225

Index

259

Acknowledgments

This book began its life during my break from teaching that I enjoyed at the Institute of International Business at the Stockholm School of Economics, in the latter months of 2000; and it received its present form, more or less, during a second break at the Aarhus School of Business in Denmark in 2002. Thus I owe much to my Scandinavian colleagues. The book's concerns date from my work on latecomer industrial strategies in East Asia, first in the semiconductor industry and most recently in the flat panel display industry; thus I owe much to my colleagues in Korea, Taiwan, and Singapore as well. For their insights and detailed reading of parts of earlier drafts, specific thanks to my esteemed colleagues Poul Andersen, Bo Carlsson, Anna Dubois, Guy Ford, Nicolai Foss, Elizabeth Garnsey, Bill Lazonick, Peter Lewin, Joe Mahoney, Peter Maskell, Steve Phelan, George Richardson, and Sidney Winter. Special thanks to Ivo Zander, who read successive drafts of the entire manuscript and offered valuable insights, and to Charles Snow, who as ever was a source of encouragement and feedback. for general comments, and invitations to make seminar presentations, many thanks to Philip Anderson, Michael Best, Jens F. Christensen, Dong-Sung Cho, Bent Dalum, Mark Dodgson, Annabelle Gawer, Andrew Griffiths, Magnus Holmen, Bruce Kirchhoff, Otto Lin, Andy Lockett, Bengt-Ake Lundvall, Maureen McKelvey, Lars-Gunnar Mattsson, Stan Metcalfe, Anne Miner, Lawrence Moss, Richard Nelson, David Vogel,

viii

Acknowledgments

Ian Wilkinson, Poh-Kam Wong, Udo Zander, and Maurizio Zollo, and to the late Sanjaya Lall. Thanks to Maureen McKelvey for giving permission to reproduce Figure 6.1 from McKelvey, Aim, and Riccaboni (2003) on collaboration in the Swedish biotech-pharmaceutical sector. Thanks to Paul Davis for the Figure 2.1 on the Schumpeterian schema. Thanks also to my research assistants Mei-Chih Hu, Kate Peterson, and Hao Tan.

List of Abbreviations

ABV DBF DCP EDI FPDs IO IORs IPRs KBT

LAN LCD LCD-TV NPV PCs PCE PDAs RBT

RBV SCP TCE TFT-LCD

Activities-based view Dedicated biotech firm Dynamic capabilities perspective Electronic data interchange Flat panel displays Industrial organization Interorganiza tiona I relations Intellectual property rights Knowledge-based theory (of the firm) Local area network Liquid crystal display LCD television Net present value Personal computers Perfectly competitive equilibrium Personal digital assistants Resource-based theory Resource-based view Structure-conduct-performance Transaction cost economics Thin-film transistor liquid crystal display

List of Figures

2.1 2.2 2.3

The Schumpeterian schema The growth of the FPD industry, 1990-2004 The crystal cycle

26 35 36

2.5

Market shares of leading firms in FPD industry, 2004 The Porter five-forces framework

40

2.6

The Taiwan FPD industry, 2004

42

5.1

Improvements in routines in Korean semiconductor sector The Swedish network of R&D collaborations in biophannaceuticals Neuronal interconnections: the foundation of learning and intelligence Strategizing by the firm in disequilibrium cycles A dynamic competitive forces framework

2.4

6.1 6.2 7.1 8.1

37

94 103 118

122 161

STRATEGIZING, DISEQUILIBRIUM, AND PROFIT

1

Introduction

My aim in this book is to offer an account of strategizing by firms without introducing any of the equilibrium-based assumptions that are found in mainstream economics. The book is a sustained reflection on what strategizing might look like when viewed consistently from a disequilibrium perspective. My goal is to demonstrate that the interesting issues encountered in the strategy literature today-issues such as the strategizing involved in formation of networks, in innovation and technology licensing, in balanced versus unbalanced industrial development pathways, in the building of business models around modular systems, in seeking entry to industries during upturns or downturns-all share a common feature, namely that they are best illuminated and analyzed as disequilibrium phenomena. The assumptions of perfectly competitive equilibrium do not fit such situations and indeed destroy the possibility of fruitfully analyzing such situations from a strategizing perspective. I develop a framework in this book within which these phenomena may be treated and elaborated as firms seek profits in a disequilibrium setting. This framework is grounded in a theory of the dynamic business system that is traced to Schumpeter, a theory of profits traced to Knight, and a theory of the firm traced to Penrose. In the framework offered, on the basis of the insights of these three giants of twentieth-century economics, firms are viewed as bundles of resource- and activity-systems, operating in markets for resources (traditionally, factors of production) and in markets

2

Introduction

for goods and services and where their strategic options are brought into focus, rather than equilibrium conditions. It is the entrepreneur's job to create such bundles, in response to perceived opportunities and activities supported by consumer demand. It is the management's job, as hired, to build the routines that connect the firm's resources with its current activities. Firms engage with such markets and seek to earn profits, defined in a Knightian sense as residual earnings after all contractual claims (incurred for use of resources) have been met over a defined time span. Profits earned through active search are contrasted with rents, which are viewed as passive earnings at imperfect equilibria. The markets in which firms engage are in constant disequilibrium, meaning that over time firms can never be sure of the commitments they are making and are always engaged in the testing of market conjectures. This is the essential entrepreneurial character of the firm. All these strategizing issues are contrasted with the firm as viewed in an economizing framework, where it is its responses and adaptation to shifts in prices, at equilibrium, that is the object of interest. The simple point is that real firms in real business settings need to be understood as acting in both strategizing and economizing mode. The concepts in the book's tit!e-strategizing, disequilibrium, and profit-have mixed histories, some cognitive overlap, and some dissonance. Strategizing, which I am using in an active sense, generally conveys a sense of firms' maneuvering for position, differentiating themselves from each other, and seeking competitive advantages over each other. By contrast, the concept of "economizing"-as introduced by Williamson ( 1991) in a well-known article-carries connotations of firms seeking efficiency and optimality. So strategizing is seen as unproductive maneuvering, as when firms charge excess prices and capture profits because of their monopoly market positions. Economizing carries connotations of firms' behavior meeting the efficiency criteria of perfectly competitive equilibrium, which in turn conveys a notion of social optimality (all resources being put to their best possible uses). Strategizing thus carries connotations of slackness, contrivance, and using muscle to secure profits that would otherwise be competed away. Disequilibrium is contrasted, of course, with equilibrium. The idea of economic equilibrium is one of the oldest and most admired in the whole corpus of economics scholarship, and the Arrow-Debreu

Introduction

theorems regarding the existence and uniqueness of perfectly competitive equilibrium (PCE) are one of the most profound results to be found in the social sciences. The idea of perfectly competitive equilibrium has become so central, so axiomatic, that its absence is now referred to routinely as a case of market imperfection, or market failure, or information asymmetry, and so on-all terms connoting a departure from the ideal. Yet there is a marked cognitive dissonance between the perfect equilibrium of these economics models and the day-to-day business reality that real firms face-one where prices have to be discovered, where competitors' innovations can take away your market, where competitive intelligence has to be paid for (as opposed to the assumption securing PCE that information is costless and instantaneously transferred), and so on. Disequilibrium by contrast evokes chaos, unpredictability, messiness, risk, and uncertainty. It is uncharted territory. 1 Profit as the general goal of firms is contrasted with rents-widely viewed in the prevailing strategy literature as the firms' goal. Let us grant, for a moment, that firms indeed seek to maximize their profits-not in the sense of solving a constrained maximization problem formulated as a production function, but in the realistic sense that if firms do not seek profits, and instead seek market share, or endless product innovation, at the expense of profits, then eventually they will die. Let us grant, further, that firms strategize around the pursuit of such profits-not necessarily in the negative sense of protecting cosy monopolies, but in the positive sense of seeking to enhance their performance, or their customer service, or their product lineup as a purposeful initiative. Where, then, do firms earn such profits? This would seem to be a reasonable question-and yet when we search for an answer, we make surprising discoveries. For a start, we find that economics replies that all profits sum to zero at equilibrium (a direct consequence of the optimality conditions). On the face of it, this makes equilibrium an unpromising place in which to frame profit-earning strategizing initiatives. Furthermore we find that strategy scholars assert that profits are earned at equilibria, but only if they are imperfect-such as when firms produce in markets with few competitors, or purchase their resources in markets where they have an information advantage. So equilibrium, whether perfect or imperfect, dominates the discussion. The most obvious point, that profits are actually earned in disequilibrium and are generated because of the strategizing behavior of firms, seems to

3

4

Introduction

escape both camps. This, then, is the starting point for my exploration of strategizing in disequilibrium. My goal in this book is to demonstrate that it is indeed worth running the risk of entering new territory in order to explore, in a provisional way, how strategizing might look from the perspective of disequilibrium. Actually, there is nothing strange about the concept of disequilibrium. It is referred to, implicitly, whenever scholars or business people discuss the role of innovation in firms' behavior (as opposed to continuing with the same products, or processes), or when they discuss networking between firms (as opposed to dealing atomistically in markets) or discuss industrial or entrepreneurial dynamics. All these involve the development and sustaining of links between firms; they involve change and tipping the balance one way or the other. None of these notions, widely discussed in the business press and scholarly journals, depend for their meaning on a notion of perfectly competitive equilibrium. In fact, they cannot make sense in such a setting. But they are rarely explicit about their making sense only at positions away from equilibrium. My purpose is to make that sense explicit and, indeed, to make the case that such accounts can only begin to make sense when cast in disequilibrium terms. Many management scholars are likewise starting to ask what organizing-away-from equilibrium might look like. The disruptive uncertainties associated with such phenomena as new network forms, or shifting industry boundaries, or technological discontinuities, are coming to be interpreted as instances of fluctuations in organizational fields and as sources of strategic opportunity. What might strategizing in disequilibrium look like? 2 To what extent have nontraditional disciplines in economics, such as Austrian theory, contributed to the development of an alternative to equilibrium-based strategizing? 3 To what extent have management scholars generally allowed themselves to be constrained by what Abbott (2001) calls a "general linear reality"-or a set of causal beliefs about how the world functions in equilibrium terms-and to what extent may this be impeding an understanding of the forces shaping the strategic options faced by entrepreneurial firms? My approach to making sense of disequilibrium conditions is to start with the concept of profits and to ask how, and where, profits are earned. This leads to the proposition that profits (carefully defined in a Knightian sense) are extinguished at a position in economic space termed

Introduction

perfectly competitive equilibrium (PCE). This in turn leads to thinking how PCE must appear to a firm that has positioned itself in disequilibrium and is earning profits. From this perspective, profits earned by firms capturing synergies from their complementary resource bundles, are reduced to zero at PCE where all resources are assumed to be perfectly substitutable. Profits earned by firms capturing increasing returns from the reconfiguration of their value chains are reduced to zero at PCE where constant returns are assumed to prevail. Profits earned by firms through networking are reduced to zero at PCE where no contact between firms is presumed to exist. Profits earned by firms through treating markets as segmented, that is, by treating consumers as heterogeneous, are reduced to zero at PCE where all consumers are assumed to be homogeneous. Above all, profits earned through innovation are reduced to zero at PCE where all technical possibilities are assumed to be known and firms are assumed to be operating at these efficient boundaries. At PCE, by definition, there is no uncertainty, no inefficiencies, and no "strategic opportunities." Thus I link strategizing, disequilibrium, and profit in what seems to be a perfectly straightforward way. This approach to a theory of competitive behavior should properly be grounded in the notion that profits can be earned in a variety of ways, all involving active interventions by the firm in disequilibrium, and that they all involve entrepreneurship as a way of overcoming the irreducible uncertainty associated with all business ventures. Knight formulated the issue as a distinction between risk, which can be mitigated by contractual payments, including insurance, and uncertainty, where no such solution is possible. Uncertainty from this perspective can only be overcome by action, by experiment, and by testing an idea to see whether it works. Competition in any real sense, where firms duel with each other, launch pricing blitzes, and fashion new products to open up new markets, must therefore be identified with entrepreneurship and innovation. I contrast this position with that found in most texts on strategizing, where the emphasis is on earnings secured at equilibrium, not through the positive interventions of the firm but through various imperfections and obstacles and frictions in market structures, such as absence of competitors, scarcity of resources, or mobility barriers such as "resource barriers" to entry in a particular sector-a perspective encapsulated in the view that for firms to earn profits, there must be ex ante and

5

6

Introduction

ex post limits to competition. In the disequilibrium setting to be presented, no such limits are imposed. Such a perspective is likely to be sterile unless it is accompanied by a sufficiently rich conceptual formulation of the strategizing firm itself. In this book I offer an account of strategizing that is based on the three fundamental categories needed to describe strategic choices made by firms: their resources, the activities that can be activated with the resources, and the routines that link the two together. Thus firms acquire resources as their source of productive services; the activities generated by such resources (and constrained by the resource bundle) generate the firms' revenues, and managers build the routines to connect the resources to the activities. Each of these three fundamental attributes of the firm is subject to strategic choice and creative management control. The dynamics of the reconfiguration of activities by firms, resource exchange, imitation and recombination, and the building of new routines and hierarchies of routines, within and between firms, thereby come into focus. This is an account of firms that provides the conceptual richness that was lost in the reduction of the firm at PCE to a point in production space. Such an account builds on the conceptual advances already registered in strategic management, where views on strategizing have been formulated in terms of activities (the competitive forces view), resources, and the dynamic capabilities embodied in the firms' routines. It remains to be demonstrated that this is more than a mere synthesis and that it provides the necessary connection between the strategizing behavior of firms and the evolutionary and dynamic processes of change and creative destruction operating in disequilibrium that are observable at the level of the economy as a whole.

Strategy versus Economics

Why do I see strategy as a suitable setting for such a discussion, rather than the field of economics proper? After all, it has long been observed in the economics community that the economy is a dynamic system, that it is frequently disrupted, and that disequilibrium conditions are more likely to be found than equilibrium conditions. Throughout the twentieth century, voices have been raised against the extreme unrealism of the equilibrium-based neowalrasian synthesis, with its extremely unrealistic

Introduction

assumptions of consumer behavior on the one hand and its minimalist portrait of "the firm" on the other-all operating as automata, endowed with fixed decision criteria, assumed to have perfect information covering all possible technological mixes or utility comparisons between goods, and so on. There was Schumpeter's original challenge when he declared that the capitalist economy "never is and never can be a stationary system" and hence needed to be analyzed from a dynamic perspective as well as an equilibrium-based position. Then we have Kaldor (1972) with his assertion of the "irrelevance of equilibrium economics," Kirman (1989) with his claim that "the emperor [neowalrasian economics] has no clothes," Clower ( 1994) with his likening of the neoclassical edifice to a logically perfect construction without any practical application, and Blaug (1997) with his identification of "disturbing currents" in economics, not to mention the students in Paris and Cambridge who have organized petitions protesting against the aridity of general equilibrium theory. I find this literature and the issues it raises to be interesting and challenging. But the point of mentioning it is to underline its complete impotence and lack of impact within the profession of economics itself. By now, thanks to Kuhn, we know how paradigm shifts are effected within scientific disciplines. We know that it is a slow process; that the discipline under siege assumes ever more rigid postures in the face of attack; that it is undermined not from within, by forces wielding arguments based on logic, but from without, by observations and novelties that are simply "impossible" in the ruling scheme of things. All this applies with some force to the situation within economics as a discipline at the start of the twenty-first century. Many of us have simply lost patience and are looking elsewhere for a more credible and realistic account of business processes. Such an account might just emerge in the discipline that has more immediate need of a credible and realistic account of business processes-namely, in the field of business strategy or strategic management. Here we have a field that already has the trappings of a discipline, in the form of journals (like the Strategic Management .Journal), conferences and academies, university-based schools and career pathways, and students and scholars eager to do PhDs-in fact, a discipline just like others in the social sciences, but with the important difference that business strategy "speaks" to practicing businesspeople, who have to deal day by

7

8

Introduction

day with the realities of a turbulent business world and who themselves quickly lose patience with the fairyland assumptions of mainstream economics. The point of these remarks is certainly not to set one paradigm up against another, with firms having to make a choice between whether they behave in "economizing" mode or in "strategizing" mode. Each mode decidedly has its place in accounting for the observed behavior of firms in real business systems. Much of this behavior involves firms adjusting to changes in inputs, signaled through the price system, and to changes in demand, again signaled through the prices of outputs, in ways that are completely described by the static adjustment frameworks of microeconomics. But much of it escapes this framework-the entry and exit of firms into and from industries, the rise and fall of industries, the creation of path-dependent technological and market trajectories, the origins of cluster and network dynamics, and so much more besides; all of this calls for a framework quite distinct from that which informs traditional microeconomics. To encourage the emergence of such an alternative framework, one that is attuned to the realities of business dynamics, is the principal aim of this work. This new field already has its intellectual heroes, scholars of renown such as Michael Porter, Jay Barney, Sid Winter, or David Teece. They have made signal contributions, which I am the first to acknowledge. But one thing can be said with conviction. The field of strategy does not yet have an alternative ruling paradigm. There is still the sense in the field of strategic management that we are "applying" the lessons of economics in the business world and that behind the strategizing of firms and their search for "rents" (an interesting term that we will come back to) there lies the solidity and dependability of economic equilibrium and the methods of comparative statics. These are the fixed points of the discipline of industrial organization, itself an applied field of economics, which is implicitly held to provide the intellectual foundations of the discipline of strategy. The field inevitably turns to economics for approval and absolution of its departures from the strict paths of equilibrium-based virtue. My argument is that it should no longer do so. The most interesting features of strategizing issues faced by firms simply do not fit within the frameworks utilized so far in economics, or even within the

Introduction

mainstream field of strategy. The problem is that much of the interesting work in strategy that documents the behavior of firms at the frontiers of biotechnology, ICTs, and other knowledge-intensive sectors, both individually and in networks and clusters, seems to escape the frameworks of traditional strategizing discourse. Such examples could involve firms collaborating in innovation through distributed capabilities, exchanging resources through contractual links or mergers, building novel routines for the appropriation of resources (technologies) from other firms, or building technology platforms that span firm boundaries. They could call for the capture of economies of scope from shared resources across markets, the capture of economies of substitution in modular systems, or the capture of returns from the evolutionary dynamics of technologies, such as in the case of latecomer firms from the Asia-Pacific region arriving unheralded in advanced sectors like semiconductors through external leverage of the resources required, rather than through prolonged internal resource accumulation. All these examples, and many more, appear to escape the net of traditional accounts whether they be resource based or activities based (the competitive forces school), since these accounts place their emphases on individual firms securing and sustaining advantages on the basis of their prior strengths, analyzed from a comparative static perspective rather than a longitudinal, evolutionary, and dynamic perspective. One could argue that it is only in a disequilibrium setting that these problems come to life. So the disequilibrium revolution is likely to erupt not in economics but in strategy. This is the conviction that underpins this book and that leads me to explore the domain of disequilibrium as the appropriate setting for the strategizing firm. Strategizing versus Economizing

In this book I will bring out the salience of the disequilibrium setting by contrasting a notion of strategizing, defined as referring to competitive behavior in disequilibrium, and economizing, defined as optimizing behavior focused on the notion of equilibrium. It was Williamson (1991) who introduced the distinction between strategizing and economizing behavior. He used the terms rather differently than I, attributing notions of efficiency to economizing behavior and notions of rent-seeking and

9

10

Introduction

manipulation of market power to strategizing behavior. In departure from Williamson's usage, I give the term strategizing a much broader, market process and entrepreneurial flavor. It is concerned not just with a firm defending an existing market position, but with how firms create such positions in the first place and how they maneuver with each other along the way. It is strategizing with respect to prices, product quality, and innovation. Likewise I use the term economizing in a sense that pertains to equilibrium notions of efficiency, encompassing all objectivizing behavior imputed to firms and economic agents in mainstream neoclassical analysis. Note that I am not saying that economizing around equilibrium is of no importance. On the contrary, much of what firms do is precisely described as economizing behavior, as captured in the textbooks of microeconomics. Conditions in product markets change, and prices of inputs or of outputs vary, leading firms to vary their activities (e.g., change their product prices, alter their product mixes, or vary their inputs). A competent firm has to be able to make these adjustments, or it rapidly goes out of business. The point is that this is not strategizing behavior; it is merely adjustment of operations around a putative equilibrium. Strategizing behavior is something quite different. It involves rivalrous behavior in the sense of one firm seeking to secure an advantage over another through innovation or imitation, which involves making creative changes to its activities configuration, its resource bundles, or its routines-all categories that are under management control. A firm can formulate a strategy of entering a new line of business as a challenger to existing incumbents and strategize around the choices available to it for making such an incursion-identifying the resources required, where they can be obtained, and whether there is time to develop them internally or to secure them from outside; and if so, on what terms, and so on. These are all strategic choices that involve the firm in viewing its resources and its activities as dual aspects of its existing operations, and even more importantly, as a base from which to launch new strategic initiatives. It is not a perspective that is grounded in notions like "self-interest seeking with guile" or principal-agent formulations that assume that managers cannot be trusted; it is in this sense a "positive theory" offering positive advice to managers. 4

Introduction

And yet the approach offered here, grounded in disequilibrium, is something rather different from what is usually meant by a "strategic theory of the firm," which is generally grounded in mainstream economic formulations. The originator of the concept, Richard Rumelt, was quite explicit in saying that "it appears obvious that the study of business strategy must rest on the bedrock foundations of the economist's model of the firm" (1984:557). While there have been numerous efforts in recent years to formulate the relations between strategy theory and economics, thus clarifying the picture, none seems to have taken this particular tack of insisting that strategizing is something that firms do most successfully away from equilibrium. 5

Outline of the Chapters

With these initial reflections, let me outline the shape of the chapters to come. We start in Chapter 2 with the Schumpeterian schema of a dynamic economy operating in disequilibrium, where change is evolutionary and driven by entrepreneurial initiative. I demonstrate that such a schema matches the realities of the dynamic business system in which firms operate and contrast this with the picture generated by the neowalrasian synthesis, namely perfectly competitive equilibrium, and its application in the field of industrial organization, namely the StructureConduct-Performance (SCP) paradigm. Thus, in this first foray into the field, we pose the Schumpeterian schema and the SCP paradigm as two divergent views of how the economy works from a strategizing perspective and ask which gives greater insight. We test their predictions in a real case, namely that of the flat panel display industry, an industry that has grown astonishingly fast over the course of the past decade and that demonstrates cyclical industrial dynamics. The comparison is fruitful. In Chapter 3 we define strategic goals in terms of the search for profit, defined in the Knightian sense as the residual left after all contractual payments to resources have been accounted for. Such a definition is based on attributing all income flows in the economy to either a contractual origin or a residual (associated with irreducible uncertainty) and connects the earning of residual income with entrepreneurial discovery and dynamic competitive behavior. This is contrasted with the assumptions

11

12

Introduction

that rule at perfectly competitive equilibrium. The focus on the source of profits thus leads to a direct contrast between equilibrium and disequilibrium, making it clear why strategizing needs to be framed in the more general disequilibrium setting. In Chapter 4 we contrast the search for Knightian profits, earned in disequilibrium, with the conventional approach in the strategy literature where strategizing by the firm is held to generate rents, or earnings, "above normal" at an imperfectly competitive equilibrium. This was an unfortunate road for strategy scholarship to take, for it carries over to strategizing all the assumptions of equilibrium and induces a view of strategizing as the passive receipt of rents rather than an activist search for profits. It has been elaborated in a conceptual inflation-including organizational rents, managerial rents, and even entrepreneurial rents-that obscures the real strategic and interventionist goals that guide the firms' behavior. In Chapter 5 the focus shifts to the firm itself as a vehicle of strategizing, starting with the picture presented by Penrose of the firm as a bundle of resources. Resources are defined as assets that provide productive services that can be captured by the firm in the form of activities, where the precise manner of capture is subject to strategic choice. To be so used, resources need to be associated with well-defined property rights, which facilitate their transfer and exchange (as in technologies licensing); the strategic choices involved in capturing the productive services, and in choosing whether to exploit resources internally or through external hire, are thus brought into focus. Activities, understood as transformation of inputs into outputs, can then be formulated as a value chain, or value constellation, where strategic choices are to be made over the boundaries of the constellation and the interfaces between firms. Management routines can then be strategically constructed to effect the linkages between resource bundles and activities, where the firm's efficiency can be captured in terms of the capabilities embodied in the routines and their interconnections. I argue that this extended Penrosean framework, couched in the elemental categories of resources, activities, and routines, provides a sufficiently rich picture of the strategizing firm and its capture of competitive advantages and one moreover that is to be contrasted with the deterministic neoclassical vision of the firm as a mere production function responding automatically to price signals.

Introduction

The picture is extended in Chapter 6 to encompass the firm embedded in its multiple connections, so that strategizing has to be applied not just at the level of the firm, but at the level of the firm's immediate partners, and in terms of the multiple interconnections that make up the network as a whole. The same framework, involving resources, activities, and routines, can be shown to provide a setting for strategizing at this new level of recursion and to generate insights into the industrial dynamics through which networks and clusters are formed. The competitive advantages of the individual firm are thus extended to a discussion of the collaborative advantages achieved by firms acting in concert. In Chapter 7, the focus is shifted again to encompass the economy as a whole, where the interaction between firms, and the structures they form, is the object of interest. Consistent with a strategizing perspective in disequilibrium, the dynamics of the economy are built up from the entrepreneurial initiatives of firms, from the industrial dynamics unleashed by entrepreneurial initiatives, and from the evolutionary dynamics that unfold as firms generate variety through their different strategies and through the suprafirm structures that their initiatives create. A link is thus established between strategizing as entrepreneurship and the generation of industrial dynamics, and in a wider sense, with evolutionary dynamics in the economy as a whole. This chapter draws the Schumpeterian, Knightian, and Penrosean threads together and elaborates a systematic account of strategizing as constrained choice within the resource-flux economy. In Chapter 8 we return to our point of departure. Strategizing in disequilibrium is shown to provide a general framework that is able to capture all three of the major disciplines in the prevailing strategy scholarship, namely an activities-based view (ABV), a resources-based view (RBV), and a dynamic capabilities perspective (DCP). This is dubbed the RARE framework, since it is grounded in the firm strategizing around Resources, Activities, and Routines, all in an Entrepreneurial setting. The advantage offered by this RARE framework couched in disequilibrium is that it generates not just the comparative static versions of strategic frameworks, familiar from the work of Porter, Barney, and many others, but also their dynamic counterparts. In doing so, it brings out the relations between them, so that they may be viewed as different perspectives on the same business totality.

13

14

Introduction

Concluding comments are then offered in chapter 9, where the potential strengths of the disequilibrium perspective are outlined and contrasted with the insights available through the concept of equilibrium. The pursuit of Knightian profits in disequilibrium establishes a platform upon which the various functional disciplines of managementsuch as marketing, new product development, supply chain management, and so on-may be erected and comparatively developed. This creates the possibility for the emergence of a unified approach to management. In a field as badly Balkanized as management, where one discipline is barely able to converse with another, this in itself is no mean achievement. The text is rounded out with two appendices, one on strategy and entrepreneurship and the other on strategy and profit. Both topicsentrepreneurship and profit-have been shockingly neglected in mainstream economics, because they do not easily fit within the canons of neoclassical discourse. That is all the more reason why they should find a natural home in strategy; this is where they will likely experience a renaissance in their study in the coming decades. Now let us move to the exposition proper. All strategizing takes place in the dynamic conditions of the free-market system, which is still best captured in totality by what might be described as the Schumpeterian schema. This is the framework of dynamic competition that treats the economy as one of interacting free economic agents, where novelty is introduced by specific agents called entrepreneurs, who are able to reassemble productive resources through securing access to instruments of credit. The actions of entrepreneurs unleash waves of change through the economy that are experienced as cyclical fluctuations. Far from business or industry cycles being seen as pathological, in the Schumpeterian schema they are seen as signs of vitality-signs that innovation is doing its work, and the new is being allowed to replace the old. Such a process was captured by Schumpeter in his immortal term creative destruction. So let us start our exposition by investigating just what Schumpeter meant by this phrase and how it can be linked to the strategic goals pursued by firms.

2

Capitalism Is Not and Never Can Be a Stationary System

Capitalism, then, is by nature a form . .. of economic change and not only never is hut never can be stationary. .. . This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in . ... Economists are at long last emerging franz the stage in which price competition was all they saw. As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position .. .. But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance)-competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. Schumpeter, ]. (1942/197 5), Capitalism, Socialism and Democracy, pp. 82-4

Our starting point has to be, as recognized so clearly by Sebumpeter, the dynamic, restless and pitiless features of the business system that we know as capitalism. There can be no other starting point for a framework of strategizing that is adequate to the complexities and subtleties encountered by real businesses as they negotiate their way through an ever-changing environment. In the short passages of the epigraph, which contains possibly the most famous lines penned by any economist in the twentieth century, Schumpeter identifies five sources of change that are all the fruit of strategizing, rather than of static adaptation to price changes. For a firm, creating a new form of organization, a new range of products,

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Capitalism Is Not and Never Can Be a Stationary System

or a new source of supply-things we would now describe as innovations in the value chain-is the feature identified as that which demands a response; firms that find a way of responding can survive, while those that do not are unceremoniously swept from the stage. This is what Sebumpeter famously called the process of creative destruction. As he put it, it is the "essential fact" about capitalism; it is the raison d'etre and the rationale of the system. 1 It is the only vantage point for understanding the tremendous innovative capacity of the system and its vast achievements in the 200-odd years that it has operated as a world system. While Schumpeter was right about the sources of internal dynamism of the capitalist system, he was unfortunately mistaken when he predicted that economists were at long last coming to see something other than price competition. He would no doubt be as shocked as ourselves to open a microeconomics textbook today, 60 years later, and find the same, comparative static treatment as was given in his day, and had been given for several decades earlier, dating from Marshall. The discipline of economics seems to have developed effective immunity against any view contrary to the prevailing neowalrasian static equilibrium framework. But not so in the related field of business history. There, historians like Alfred Chandler observe the facts and agree largely with Schumpeter's assessment. Indeed, there is striking concordance between Schumpeter's observations and those of Chandler, the "dean" of twentieth-century industry studies, on the strategies of large firms seeking competitive advantages over each other. 2 Chandler's description seems to have much more in common with a view of the disruptive effects of new technological and organizational forms on the economy, in keeping with Schumpeterian insights, than with a view of static adjustment to price-guided changes. No doubt there are many reasons why Schumpeter and his brand of dynamic analysis did not sweep the field of economics off its feet, but instead ended up with Schumpeter being marginalized as the wry and caustic observer. One reason is no doubt the fact that tools for disequilibrium analysis were not available at the time that Schumpeter was writing; these tools have become available only much more recently, with computer-based modeling and the analysis of complex systems and emergent phenomena. 3 Another reason is doubtless Schumpeter's own antipathy to developing a "school" of thought, where cumulative knowledge might be developed to oppose the neoclassical mainstream. 4

Capitalism Is Not and Never Can Be a Stationary System

One factor was certainly the absence of clear and compelling evidence at the time that his insights were correct. Decade after decade, economists who were familiar with business realities (and not all of them were) could point to large firms and their continued profitability. They could point to the relatively slow transitions from one industry to another and argue that these were features of a system that, over time, was accommodating to large changes by a number of small steps. But this is no longer a valid defense. By now, there is overwhelming evidence that the process of creative destruction proceeds just as described by Schumpeter. This new perspective emerged along with the evidence regarding new firm formation that started to be collected systematically in the 1980s. New Firm Formation and Creative Destruction

The most famous aspect of the Schumpeterian schema involves the notion of "creative destruction," whereby Schumpeter was alluding to the competitive power of innovations that break up the old features of the economy and make way for the new. In arguing for his dynamic conception of the workings of the economy as a whole, he noted in Capitalism, Socialism and Democracy (1942) that "the problem ... usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them. " 5 New firm formation is an index of resource recirculation and dynamic flux in an economy. Entrepreneurs extract resources from present uses and recombine, or repackage, them to fit new strategic goals. In this way, they open up new pathways, where other firms can follow, or they directly challenge incumbents, with new variations on existing products or new approaches to marketing, or through some other kind of innovation. In this way they "destroy" existing structures and drive existing firms to meet their innovations, or succumb. As incumbents fall behind the leading competitive edge, either they are revived by an infusion of new management (recovery) or they die, and their productive resources are taken up by other firms and adapted for new ends. It is this resource recirculation, or resource dynamics, that keeps the free-market system adaptive and capable of responding to new external challenges. 6 New firm formation is thus the vehicle for the introduction of radical innovations, which keep the incumbents on their toes or destroy

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Capitalism Is Not and Never Can Be a Stationary System

them. The real significance of churning, and new firm formation, lies not so much in job generation-important as this is-but in the impact that these firms have on incumbents. It is now widely recognized that innovations tend to be carried by new firms, while incumbents in general resist the innovations, through fear of undermining their own hard-won advantages. 7 This provides empirical verification of the process of creative destruction doing its work. In the United States of the 1970s and 1980s, conventional wisdom was that new jobs were created by large firms, supported year by year by cross-sectional studies of employment levels in large and small firms. The small firm sector, by contrast, was held to be the site of precarious job creation. David Birch therefore created a sensation when he published empirically sound evidence that it was small firms that actually created most jobs in the U.S. economy. Using Dun and Bradstreet data, he was able to analyze job creation in a way that linked the jobs to specific firms, which could be followed longitudinally. This approach allowed him to demonstrate industry "churning"-or high rates of entry and exit by firms in industries-as a principal index of dynamic adjustment by industries. 8 These results provided the empirical counterpart to the theoretical results already demonstrated by Herbert Simon and his collaborator Yuji Ijiri (1964 ), when they showed that the highly skewed frequency distribution of firms by size was likely to be generated by a dynamic process rather than through consideration of static cost curves. Further empirical demonstration of churning, and of the significance of small firms for entrepreneurial dynamics, was provided by studies in states such as Michigan and Minnesota, as well as countries such as Canada and Taiwan. The classical political economists certainly were aware of churning, and Marshall made his famous allusion to the firms in an industry as so many trees in a forest, destined to be eclipsed and fall as new saplings rise. Nevertheless, the pace of churning seems to have picked up, particularly over the course of the past two decades. 9 The past quarter-century has indeed seen an explosion of scientific work and enquiry into these issues, probing evolutionary and technological dynamics of the economic system in ways that depart fundamentally from the assumptions of neoclassical economics. Nelson and Winter (1982) introduced their pioneering analysis of evolutionary economic processes by making the argument that selective pressures operate on firms in terms of variations in their underlying capabilities and routines (and

Capitalism Is Not and Never Can Be a Stationary System

by extension, resources). This was a completely novel way of viewing interfirm dynamics and evolutionary dynamics. It dispensed with neoclassical fantasies, including the view that firms adjust instantaneously to changes in commercial conditions, such as changes in prices, by adjusting their production functions. Instead, Nelson and Winter argued that firms respond to changes in economic conditions through the medium of their routines, which can be varied only slowly and with difficulty. They modeled evolutionary dynamics in terms of random variations in firms' routines, tracing out the selective pressures subsequently felt over hundreds of repeated iterations-in a way taken up by numerous other scholars. 10 In a similar vein, Gort and Klepper (1982) launched another stream of work into the empirical realities of the time paths of diffusion of innovations. This work was characterized by the authors as an evolutionary theory of the diffusion of innovations and contrasted explicitly with comparative static accounts based on such notions as economies of scale and minimum efficient scale of firms (which, as we will see, underpin the structure-conduct-performance paradigm). This work too has fostered a stream of empirical studies documenting the turnover of firms in various industries and linking these turnover rates to the industrial dynamics observed. 11 Yet another stream of work was launched in 1982, with the publication by David Teece of his nonncoclassical account of the multiproduct firm. This work was explicitly Penrosean, Chandlerian, and Schumpeterian in inspiration and utilized notions such as the firm's managerial slack resources as one of the instigators of diversification. In this way, Teece laid the foundations for a strategic theory of the firm where the firm is subject to Schumpeterian competition. On the empirical side, John Sutton revitalized industrial economics with his 1991 book on sunk costs and market structure, which took a careful look at industrial dynamics in food and beverage industries across six countries and examined industry concentration and its impact on market power and efficiencies. 12 He then went beyond this in the 1998 book Technology and Market Structure, which applies new frameworks for analyzing strategy in several further industries, including semiconductors. A stream of work identified as "new" industrial organization has flowed from this book, and this work distinguishes itself from the traditional "structure-conduct-performance" school (discussed later).

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Capitalism Is Not and Never Can Be a Stationary System

The Schumpeterian schema itself has been enriched by numerous studies concerned with not only the demand side of creative destruction but also its supply side. Saviotti (1996) brought these issues to a head, setting demand-side dynamics alongside supply-side issues in an account of the economy moving through processes of technological evolution to greater levels of variety. It is variety within the economic system that is now seen as the source of innovative potential and the stuff on which entrepreneurial strategizing operates. 13 The last two decades have seen a burst of institutional work aimed at elaborating systems of innovation at a sectoral, regional, and nationallevel. 14 The processes of technological change have been embedded in institutional settings through the concept of "technological regime." 15 And "history-friendly" models have been developed to bring the theoretical and empirical aspects of these studies into closer alignment. 16 Baumol (2002) has added a twist to this story by arguing that the key to understanding these competitive pressures is that they are felt by all firms: there is an "arms' race" approach to innovation that drives all firms to match each other's efforts. 17 He argues that this is the driving force behind the incredible innovative performance of capitalism-and he is right to do so. The discipline of strategy should follow his example. So here we have in Schumpeter's schema and the subsequent elaborations of evolutionary and innovation dynamics by scholars such as Nelson, Winter, Klepper, Sutton, and Baumol, a point of departure in laying the foundations for an adequate theory of dynamic competition and of strategizing. Such a theory must start from the position that the free-market economy is constantly in a state of upheaval. The conceptualization of competition as a dynamic process provides the frame within which strategizing needs to be developed. 18 The Schumpeterian Schema of Business Dynamics

Because I intend to refer repeatedly to a process of creative destruction as "Schumpeterian competition," it is worth going back to the source to verify just what is meant by the phrase. Schum peter was a wunderkind who set the German-speaking world of economics agog in the prewar years 1908-14. By then, at the age of just over 30, he had already published three books (and numerous papers and reviews) in which he

Capitalism Is Not and Never Can Be a Stationary System

had, first, introduced and critiqued the new marginal analysis for German economists; second, developed his wholly original vision of economic dynamics stemming from the internal sources of change and carried by entrepreneurial initiative; and third, penned a rapid historical survey of the entire subject. For our purposes, it is his 1912 book The Theory of Economic Development, published when he was just 28, that stands as the manifesto for a different kind of approach and to the core of which he was faithful for the rest of his professional career. Schumpeter laid out in this book a schema that was at once a vantage point, from which to view history, giving it an empirical bias; and a theoretical "model" or generalization of experience, from which economic principles could be drawn. It could even have become, had he chosen to take it in this direction, a source of policy prescriptions. But this was something to which he maintained a distinct aversion for the whole of his professional life. In a way probably unanticipated by Schumpeter, we are going to take the schema as the starting point for a discussion of strategizing by firms in conditions of turbulence and disequilibrium. 19 Consider an economy where firms are continually adjusting their activities in response to changes in conditions. Producers respond to shortages by raising prices according to a specified supply-price schedule. Consumers respond by reducing their purchases according to a specified demand schedule. Such an economy can be very active, with firms and individuals adjusting their behavior continuously in order to adapt to changes (which occur mainly outside of firms), such as changes in supply conditions or in the size of the population. But this economy is also static in the sense that it does not have a source of unpredictable, disruptive change that could send it in a new direction. The economy is at or close to equilibrium, so that all change can be treated as incremental and continuous. This basic model of the economy-what has been called the "stationary state" or the "circular flow" -dominated the theory of the firm for decades. It is a framework where change occurs only when firms respond to external influences. Now imagine an economy that can change in unanticipated ways because of internally generated processes. Some firms, which may be called entrepreneurial firms, secure access to resources and recombine them to develop new lines of business. To ensure that entrepreneurial activity is not marginalized relative to the existing economy, consider the existence

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of a credit system that facilitates entrepreneurial behavior. Credit can be created by or drawn from the banking system, obtained through the sale of company stock, or (in later years) received from venture capitalists, enabling entrepreneurial firms to draw resources away from their current applications and put them to new uses. The presence of credit disturbs the monetary system, while the entrepreneurial demand for resources disturbs the price system, such as the prices for capital (interest) and labor (wages). Thus, a healthy credit system facilitates innovation and entrepreneurial initiative. This conception of the economy is due largely to Schumpeter (1912/1934). His writings show that an adequate description of an economic system is not solely as a mechanical clock perpetually moving around a position of rest, or equilibrium, peopled by uniform firms with uniform motivations, but as a dynamic, evolving system experiencing novelty caused by the actions of large numbers of independent agents mutually engaging with each other. If anything, such an economic system is in perpetual disequilibrium with unpredictable consequences. Schumpeter understood that the static view could be valid at any particular point in time, but a truly realistic account of the evolutionary dynamics of such a system would need to consist of more than a series of comparative snapshots. A truly realistic account would have to engage with the source of the dynamics and its effects as they are propagated through the system. The focus of interest in such an economic system is the process of dynamic competition, where one group of firms displaces another, and firms within such groups compete for market share. Thus the focus is on the process through which interfirm competition drives open-ended (or evolutionary) development. There are measurable features of such a dynamic framework-such as the time taken between an innovation and its competitive imitation by follower firms. In Schumpeter's system, such a measure is an index of the health of the competitive dynamics in an economy. 20 Schumpeter introduces the notion that the most fundamental form of competition is that between lines of business-as between canals, railways, and stage coaches in the nineteenth century; between oil-based, coal, nuclear, or solar energy systems in the twentieth century; or between cable, satellite, wireless, and telephone for delivery of Internet services in the twenty-first century-rather than between firms producing similar products. The strategic orientations of incumbents and challengers

Capitalism Is Not and Never Can Be a Stationary System

are therefore quite different. A supplementary result is that temporary monopolies achieved through innovation, in the process of fair competition, will always be undermined by imitation and improvement, in a process of clustering of activity in the wake of the success of a new line of business. Thus public concern over market power is misplaced, provided there is healthy innovation and fair competition (e.g., restraint of cartels). More fundamentally, the action of innovators will generate a swarming, or clustering, effect as imitators introduce replicas or variants of the new combinations. The macroeconomic insight generated is that this swarming, or clustering, in the wake of successful creation of new lines of business, inevitably leads to cyclical phenomena, or business cycles. These consist in an upswing as capital and resources are drawn into the new line of business, driving up prices and factor prices until a position of saturation is reached and the peak passes. (This might involve the bursting of a speculative bubble.) This is inevitably followed by a downswing as entrepreneurs redeem credit instruments (i.e., debts are repaid out of current earnings) and competition reduces profits or induces losses, thus squeezing all the activities dependent on them. Thus public concern over the "waste" involved in business cycles is misplaced, for this is the mechanism through which economic renewal takes place. 21 By contrast, the microeconomic insight is that change is endogenous, arising from the initiatives of entrepreneurs (leaving aside, for the moment, just who is an entrepreneur), who assume the power to redirect lines of activity, and divert resources from one use to a new use, through their access to credit. This emphasis on the sources of change, and on the processes through which these sources are constantly being renewed and forced to assert themselves by the system itself, is the defining feature of the Schumpeterian system. By contrast, in the prevailing frameworks that have informed economics and have carried across to the newer field of strategic management, we find an emphasis on stability, on stasis, and on adaptation as a response to external events. In the 1912 book, this is the set of dynamic interactions that Schumpeter refers to as "the economy as a whole," meaning that the dynamics are to be sought not in the behavior of individual firms or consumers but in their mutual interaction and the "emergent" cyclical behavior generated. It is economic cycles that are seen by Schumpeter

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as the fundamental "emergent" properties of the system. Indeed, these properties may be taken as defining what distinguishes a "Schumpeterian" from a "non-Schumpeterian" approach: to be Schumpeterian, a framework, schema, or model must generate business or industry cycles as emergent (not preprogrammed) phenomena. Schumpeter discusses entrepreneurship in many different forms. His early emphasis on the heroic individual is tempered by experience (including personal experience) and by observation of innovation in largely oligopolistic industries, and so in his 1942 masterpiece, written 30 years later, Capitalism, Socialism and Democracy, there is much more emphasis on the function of entrepreneurship rather than on the specific form that it takes. This is entirely consistent with his 1912 exposition. The point is that the process of entrepreneurship is in both cases viewed as the source for instability, disrupting the "circular flow" and creating new lines of business that challenge the old and subject it to creative destruction. 22 Consider now the originality of this vision of "the economy as a whole. " 23 It starts from the assumption that the proper description of the economic system is not as a mechanical clockwork, perpetually moving around a position of rest, or equilibrium, peopled by uniform entities with uniform motivations, but as a dynamic, evolving system creating novelty through the emergence of unexpected phenomena from the strategic actions of very large numbers of independent agents mutually engaging with each other and creating a collective reality. The key insight is that the evolutionary dynamics of such a system are generated from its internal processes, involving entrepreneurial discovery and new business line creation, rather than from external shocks such as shifts in population or wars and revolutions. Obviously, these are a source of disturbance, but do not, on their own, account for the intensity and ubiquity of variation and selection processes within the economy. Thus protection from external shocks is not a plausible way of "smoothing" the paths of development for economies. The key insight is that the mutual interaction between agents, and their technological competition, generates cyclical behavior patterns that cannot be predicted in advance. This cyclicality is the hallmark of economies seen as complex adaptive systems, from a Schumpeterian perspective. I propose to call this collection of propositions (or hypotheses) the Schumpeterian schema or framework-rather than a system on one hand, or model on the other. It is a schema in that it is more specific than

Capitalism Is Not and Never Can Be a Stationary System

a generalized system, but not as specific as a "model" that should have variables specified and means of quantification available. 24 Certainly, the Schumpeterian schema as outlined (and depicted in Figure 2.1) can be specified in the form of one or more models. The remarkable thing is that the schema outlined is quite consistent with current path-breaking work in the areas of evolutionary dynamics, complexity, and agent-based modeling. In this sense, the 1912 masterpiece can be seen as a remarkable anticipation of the recent work on complexity and complex adaptive systems, where interagent activity generates "emergent" phenomena. But even more remarkable is the "fit" between this framework and that of strategizing, where firms are viewed as actively seeking for ways to enhance their competitiveness by exploring new ways to produce, new ways to combine resources, new markets to tackle, and new ways to organize their value chains. The alternative perspective, as documented in innumerable textbooks of microeconomics and as applied in textbooks on industrial organization, is the framework of static price competition, focused on the notion of perfectly competitive equilibrium and the industrial organization expression of this in a comparatively static setting, namely, the structure-conduct-performance framework. These frameworks provide the foundation for current approaches to economizing, and to strategizing, viewed as the pursuit of rents in a comparatively static framework. The first task then is to investigate these frameworks from the point of view of their fitness for providing a foundation of strategizing in disequilibrium and contrasting them with the Schumpeterian schema. A Contrast: Competition as a Static Process Taking Place around Equilibrium

The economizing perspective seeks a total view of the economic system in terms of balances or necessary relations between the operating parts. Insofar as these are products (in the activities space) and factors (in the resources space), the economizing perspective seeks to establish necessary relations between them. This is feasible only at a position of equilibrium, defined as a state where all products are produced efficiently and all factors are being used efficiently; in turn, this is considered to mean that all markets are being cleared at a certain set of prices. This is actually

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Factor Providers

Finns

Consumers

Supply I

I. Shortage

Demand 2. Price rise

Price

Schedule

Schedule

(

4. Production Reduced

3. Demand Reduced

5. Over supply

6. Price reduced

7. Demand Increased

8. Production Increased

.

-

Circular Flow/Static View

-.-------------, Economic System Consumers

Firms

Factor Providers

Economy as a whole /Dynamic View

Entrepreneurial Activity Usually new firms, sometimes existing finns

Ex isting Business Lines

Disturbs Price System

Microeconomic View Dynamic Competition One group of fim1s displaces another Finns within groups compete for market share Imitators introduce replicas or variants of the recombination ~ swannin • clustering

Macroeconomic View

Intense competitive dynamics

Disturbs Monetary System

Credit System (Banking, Equities, VC)

""""' 2.1

T he Schumoeteri a n sch em a .

Swanninglclustcring results in cyclical phcnomemt (business cycles) • Upswing in demand for capital and resources for the recombinations drives up prices and factor prices Until a saturation point is reached. and the peak passes Then entrepreneurs redeem credit instruments, competition reduces prolits or induces losses. squeezing all the activities dependant on them

Capitalism Is Not and Never Can Be a Stationary System

a profound result, and one on which economists had to labor over the course of nearly two centuries-from Adam Smith's notions of the invisible hand bringing about social allocations that are optimal but pursued only piecemeal by individuals, through the elaboration of the concept of perfectly competitive equilibrium (PCE) by Knight (1921), to its axiomatization in the hands of Arrow, Debreu, and others. 25 The extraordinary assumptions needed to produce this result, such as the costless access to information that is transmitted to all parties instantaneously, and the necessity for constant returns to scale are well known and have been deplored for decades; but in the absence of alternatives, these results go on being elaborated as if they were the only possible ways of describing business behavior as it "ought" to be. 26 The virtue of equilibrium, from an economizing perspective, is that it simplifies discussion of business issues. At equilibrium there is only one price ruling in any market; there is equality enforced between the marginal rates of substitution between products; there is equality between the marginal efficiencies of factors of production; and total product is exhausted by the sum of marginal products (assuming constant returns to scale, discussed later). That is, there are no multiple prices, no multiple or purely local equilibria, and no inefficiencies left in the system. But it is this very neatness that dooms the concept from a strategizing perspective, which has to live, for example, with the fact that multiple prices may coexist in a single market. Indeed, a principal form of strategizing behavior is through price competition, by which one firm selects a price schedule lower than that of a competing firm. It is the very fact of the price differential that constitutes a strategic advantage. But from the economizing perspective, a price differential indicates economic inefficiency, and competitive entry by firms is assumed to occur until all such differentials are eliminated, at the position known as equilibrium. Here then is the irony of the concept of PCE, which is seen as being "competitive" by the economizing perspective in the sense that all profits are reduced to zero and all factors secure their efficient returns. There are, in other words, no sources of monopoly profits at a "competitive" equilibrium; there are no artificial sources of rents, such as governments favoring one group at the expense of another. But it is far from being "competitive" in the strategizing sense, since firms cannot exploit their relative positions with respect to each other to gain advantages, more or less temporary but earning entrepreneurial profits for as long as they last.

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When entrepreneurial profits are reduced to zero, the "competitiveness" of the economy from the perspective of strategizing has been exhausted. But from the economizing perspective of a "perfect equilibrium," the competitiveness has only just been established. This is a fundamental and irretrievable mismatch of concepts and words, which we have to live with. It is only out of equilibrium that the issues of real significance-such as how markets actually work, how innovations are created and are diffused, how firms interact with other firms to their mutual advantage-come into focus. Formal economists left behind the classical equation of "competition" with the striving of economic agents against each other and with considerations not of the end result of competition, but of its processP As they did so, they developed an ever-increasingly unworldly definition of competition and competitive equilibrium. According to an authoritative text on industrial organization theory (Scherer and Ross 1990), a market is said to be competitive (or more properly, purely competitive) "when the number of firms selling a homogeneous commodity is so large, and each individual firm's share of the market is so small, that no individual firm finds itself able to influence appreciably the commodity's price by varying the quantity of output it sells." (1990: 16 )28 The focus of this definition is to turn price into a parameter, which is not something under the control of a firm engaged in this market. So this automatically rules out of court any notion of marketing or of striving against other firms through, for example, changing a price schedule. From the perspective of the PCE, the rivalry between, say, General Motors and Toyota in the automotive industry is not perfectly competitive, whereas two farmers producing wheat on adjacent plots, each quite unable to influence the price of wheat and each being indifferent to what the other is doing, are said to be involved in a purely competitive market. Furthermore, if there are no barriers to entry, combined with perfect mobility of resources (such that firms can make instantaneous adjustments in their factor combinations in order to change outputs), then the market is defined not just as purely competitive, but as perfectly competitive. An equilibrium in such a market, around which the entire universe of economic theorizing revolves, is termed a perfectly competitive equilibrium. Although most critiques of this framework focus on the lack of realism of the assumptions needed to guarantee the existence and uniqueness of PCE, my concern is different; namely, with the fitness of PCE for purposes of strategizing by firms. It is clear that it is perfectly irrelevant to any question to do with strategizing. 29

Capitalism Is Not and Never Can Be a Stationary System

Imperfect markets: False Problems for Firms

The neoclassical economics scholarship, taking PCE as its point of reference, defines anything less than perfect information availability as a case of "information asymmetry" reflecting "market failure" or the operation of an "imperfect" market. Lengthy debates then ensue on how such market failures may be "corrected"-by policy or other interventions. From the strategizing perspective, all this is so much wasted effort. The strategizing firm, looking out for entrepreneurial opportunities, lives with the bounded nature of its knowledge of the economic system and turns "information asymmetry" into a source of entrepreneurial discovery and entrepreneurial action. 3 From the strategizing perspective, there is no point in viewing information asymmetry as a "fault" of uncertainty, to be overcome by, say, public risk insurance-for uncertainty is the source of entrepreneurial opportunity and so of entrepreneurial profits. Nor is there a "spillover" problem in information asymmetries, because of the supposed nature of knowledge as a public good, that could be interpreted as a factor working against investment by firms in their own research and development (R&D). From a strategizing perspective, firms are engaging in R&D for a variety of strategic reasons, including maintaining their technological capabilities, enhancing their absorptive capacity, and extending their strategic options. Whether other firms are likely to benefit from their R&D expenditure would not be high on their list of concerns, although such an issue does loom large in the neoclassical literature on R&D spillovers. 31 Here is a false problem-when viewed from the strategizing perspective.

°

The Structure-Conduct-Performance Paradigm

Most students of industrial organization theory do not really believe the picture of perfect competition, and so they have developed an alternative, rather more realistic, view of how industrial markets workwhile still remaining faithful to the concept of equilibrium and to the production function view of the firm. One of the most influential of these perspectives has come to be known as the structure-conduct-performance (SCP) paradigm, named after a highly influential book, American Industry: Structure, Conduct, Performance, by Richard Caves, which was first published in 1964 and subsequently in numerous editions. 32 Moreover,

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this book is the current prevailing view of how industrial markets work, insofar as it underpins current views on strategizing. So it is necessary to examine it, if only as prelude to our subsequent explorations. At the outset, let us concede the strengths of the SCP approach. It starts with differential profit rates across different industries, an empirically observable phenomenon (and one that violates the assumption of equalization of factor returns at PCE). It links these different profit ratesfirm performance-with different degrees of industrial concentration in the various sectors-again, an empirically observable phenomenon. It also links the differential performance with other aspects of firm behavior (or conduct), such as their strategies of product differentiation (market segmentation) and the maintenance of barriers to entry, through, for example, high levels of marketing expenditure or high levels of R&D expenditure. All these are empirically verifiable phenomena, in the United States as much as in any other advanced industrial economy, and they all violate basic assumptions of the concept of PCE. This snapshot approach, looking at industry as it appears at any point in time, is rounded off with a view of structure, namely, the operation of scale economies and scope economies that favor large firms and so are linked to the observed levels of industrial concentration. Market structure thus drives firms' conduct, which results in differential profit performance:13 So far, so good. The problem arises with the interpretation of these issues. It is not just that Caves never even mentions Schumpeter or that his book is largely silent on dynamic features of competition such as entry rates of firms, exit rates, technological change and innovationthe stuff of more recent "industry cycle" studies. We could live with this-but what is worse is that it frames its discussion purely in terms of "market structure" and the workings of price theory within a given market structure, thus eliminating dynamics as a point of reference at all. This framework informs current work on industrial organization and is the foundation for current approaches to strategizing, such as the Porter framework. It may not be immediately apparent, but this is essentially an equilibrium-based notion. In each industry, it focuses on equilibrium concentrations of firms and the factors limiting their number or access (entry barriers). 34 The idea is that a balance exists between the entry barriers (viewed in both technological and market-size terms) and the number of

Capitalism Is Not and Never Can Be a Stationary System

firms that can be accommodated within the industry at "normal" profitsor profits that earn the firm, at equilibrium, a rate of return on its invested capital equal to, or better than, the rate of return elsewhere. Pricing policies are evaluated, for example, against the standard of a perfectly competitive market, and so the focus is on oligopolistic pricing, the formation of cartels and the practice of "tacit collusion," and other features deemed to be contrary to the public interest. Finally performance is evaluated in terms of firms' profitability, although this is sometimes given a broader interpretation. 35 Nevertheless, the core performance criteria are firm-level profitability and the capacity of firms to earn "rents" above "normal" rates of return. The key finding, holding the framework together, is that profit rates are found to vary across industries, and a correlation can be established between high profit rates, high concentration, and high barriers to entry, on the one hand, and low profit rates, low levels of concentration, and low barriers to entry, on the other. Let us now contrast the SCP approach with the Schumpeterian view of things. The SCP approach starts with market structure as a given. 36 Market structure turns on concentration (which reflects actual market rivals) and barriers to entry (which reflects potential rivals). Industry concentration and barriers to entry turn on economies of scale, or average unit cost curves, which are held to be an intrinsic technical feature reflecting the tenet that bigger is betterY Barriers to entry are held to be exercised primarily through incumbents securing lower costs than could be achieved by challengers (because of economies of scale) or product differentiation, which spans all market segments and again makes it very difficult for a challenger to enter via any particular segment. Thus industry structure is held to determine firm behavior and general profit levels. Nothing in this system can change, since all the parts reinforce each other. Once scale economies work their effect (as they did, for example, in the automobile industry in the United States in the 1920s-the only such case discussed in Caves' book); then cost advantages become overwhelming, marginal firms are forced out, concentration ratios rise, and product differentiation completes the process of creating insuperable barriers to entry. Only antitrust actions, based on the test of "market power," can be utilized at such a point to break open an industry-so the SCP argument goes.

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In passing, notice how this story provides the foundation for Porter's clever reformulation in his 1980 book, Competitive Strategy. He takes the SCP paradigm as a given and, using its insights as prescriptions for firm strategizing, simply turns it on its head. Thus firms are advised to, first, choose an industry where profit levels are already high and then seek to maintain them at that level through the insights of the SCP by, for example, creating barriers to entry on the basis of the workings of scale economies, reducing the number of rivals and potential entrants, and practicing product differentiation for good measure. The ingredient that Porter adds is value appropriation from firms upward and downward in the value chain, and he again (in 1980) regards the value chain as a given feature of the structure of an industry. (This changes in the 1985 book, where the value chain itself is seen as an object of strategizing: an important shift, as we shall discuss later.)

Industrial Dynamics in the SCP Paradigm

Why get worked up about the SCP paradigm? It is because it offers itself as an account of industrial dynamics and yet it abstains entirely from dynamic reasoning. Instead, it offers comparative static reasoning, which, although providing accurate insights at any point in time, fails to offer any plausible account of how the system changes and evolves over time. And this should be the core, the focus, of any strategizing argument. The main point is that the emphasis in SCP on the stability of market structure, as determining firm conduct and the profit performance of industries, is ultimately an expression of technological characteristics, which themselves are considered to be unchanging features of industry structure. Firm turnover is seen as occurring only in the early stages of an industry, before scale effects start to exercise their dominance. Economies of scale, it must be remembered, are an outcome of a fixed set of technical determinants of the neoclassical firm's production function. They are not acquired by learning, experience, or innovation; they are simply "there," and their existence means that large firms that capture them will outperform smaller firms that do not capture them. Hence a market structure where large firms predominate at any point in time is observed. In the SCP framework there is never a chance for smaller firms to play a role, and churning is ignored. So goes the IO argument. 38

Capitalism Is Not and Never Can Be a Stationary System

Now consider the Schumpeterian alternative. Market structure is the outcome, argues Schumpeter, not of static technical coefficients but of a dynamic process of competition where the innovative firm ousts the incumbent. Large firms in control of an industry will set their prices above "normal" levels expected by the perfect competition theory, and so earn oligopolistic profits. These will act as a magnet for entrepreneurs, who in turn will look for ways to enter the industry, for example, by imitating the production systems of the incumbents but with lower costs (because of lower overheads) or by reconfiguring the value chain in some way. (An example would be a furniture retailer outsourcing furniture supplies to a group of dedicated producers-as done by a young Swedish entrepreneur named Ingmar Kamprad, founder of IKEA.) Through such innovations, new firms will enter the industry, attract customers, and take market share away from the incumbents. They will become, in turn, the large firmsand they too will attract imitators and challengers, who will seek to enter the industry and compete away their oligopolistic profits. The outcome at any one time is a product of the underlying dynamic processes. But the static picture of "market structure" will not reflect this turnover; it will simply show that at each point in time, a group of large firms dominate the industry. Moreover, this "market structure" view is assumed to lead to the raised profit levels in the industry. Thus the SCP view, which underpins so much of IO and, indirectly, underpins the Porter "competitive forces" view, gets things completely the wrong way round. At any point in time, it views an outcome not as the result of an underlying dynamic process, but as an expression of large firm dominance due to economies of scale; this dominance in turn is seen to result in higher profits (rather than the higher profits resulting from innovations); and the link between them is assumed to be "firm conduct" in the form of raising barriers to entry. But again, Schumpeter would argue that large R&D expenditures, widely seen as a source of barriers to entry, are in fact the obvious means available to a large firm of combating the mortal attacks of an innovative challenger. The SCP paradigm has its origins in the very understandable desire to introduce some realism into the discussion of the workings of industrial markets. But it is the presentation of the framework as one of applied neoclassical economics, embodying a production function theory of the firm and a preference for an equilibrium approach to understanding

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differences between industries, that renders it inadequate as a foundation for strategizing in disequilibriumY To see this more graphically, let us consider a real industrial setting, and moreover one that is a bit more recent than Caves's example of the U.S. automobile industry in the 1920s. Let us consider the flat panel display (FPD) industry, which, since its inception as a large-scale industry in the late 1980s, has grown to become one of the most dynamic in the world. A Test Case: Cyclical Industrial Dynamics in the FPD Industry

Schumpeter would no doubt be fascinated by the rise of the FPD industry, the latest to demonstrate extreme cyclical behavior and cyclerelated strategic choices made by firms. It has grown from virtually nothing in the late 1980s to a huge industry, with a global output value of US$62 billion in 2004 and a growth rate of something like 30-40% a year. The industry's growth has been driven by a dominant technology, namely, thin-film transistor liquid crystal display (TFT-LCD). It was this technology that enabled Japanese firms such as Sharp, Toshiba, and IBM Japan to produce stable images (more than 10 inches) on large displays, which could be used to make the screens of the new laptop computers in 1989/1990 attractive-much more so than the then available displays such as gas discharge, with its weird red glow. So here was an innovationin every sense of the word, a Schumpeterian innovation-that promised to create a new and important line of business for these Japanese companies. That the promise is fulfilled is shown in Figure 2.2, which plots the growth of the new business, driven as it is by the dominant TFT-LCD technology. This market growth has been driven by Schumpeterian innovation on both the supply side and demand side. The firms involved in the industry, which are mostly new and-to Western ears-unheard of, spent over US$10 billion in 2004 on new fabrication equipment, thus creating a new industry to service and supply the growing activities of the FPD sector. And on the demand side, new applications for these brilliant panels are continuously being developed-from the original application of flat screens for notebook computers to the rapid penetration of desktop monitors (displacing traditional CRT displays), and now from LCD TVs that are rapidly penetrating the TV market to small displays lighting up cell phones, digital still cameras, and PDAs, as well as to large displays that

Capitalism Is Not and Never Can Be a Stationary System

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