I was working through one of my papers today with Neil Kay, and we had this discussion:

Neil: I wrote a paper which essentially says ‘I’m not sure if dynamic capabilities exist, but if they do, they probably look like this’.

Me: So dynamic capabilities are the Higgs boson of economics?

Now I guess we just need to build a business version of the Large Hadron Collider if anyone aims to address Nicolai Foss’ criticisms. And the even bigger question – who will provide the funding to build it?

LHC looking for the Higgs boson

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The lead story last night on espn.com was an opinion column about the Masters (sorry – I can’t find the link for it – they appear to have buried it now).  The premise of the story is that at 7 strokes off the lead, neither Phil Mickelson nor Tiger Woods has a chance to win the tournament today.  Why, because all of the winners since 2001 have been in the final pairing.  When I started writing this, Tiger & Lefty were both 1 stroke off the lead.  It’s looking now like they’ll both fall a bit short, but it’s been an awfully entertaining day of golf so far.

But that’s not what I want to talk about.  I want to talk about forecasting.  How can you rule something out based on an 8 year pattern (especially in a tournament that has been running for 75 years?)?  We have such a strong habit of extrapolating recent trends and thinking that tells us everything we need to know.  It takes no imagination at all to do this.  But new stuff happens all the time – and the first step is always to imagine something new.  That’s the start of innovation.

Actually, if we’re extrapolating the person who really doesn’t have a chance is Kenny Perry.  After all, he’s 48 years old and the oldest Masters champion ever was Jack Nicklaus at 46.  So if we extrapolate out all of the previous 74 Masters tourneys, then Perry can’t win.  Except he’s up by 1 with 5 holes left….

Saying that something can’t be done because it hasn’t been done before is the easiest thing in the world.  It’s a lot harder to imagine something new, harder still to actually make it happen.  But that’s how innovations happen.

A significant component of economic activity in Australia is carried out in the sector of capital goods. Compared with our knowledge of innovation in consumer goods, capital goods are a poorly understood part of the Australian economy. Broadly speaking, capital goods can categorized as follows (Acha et al. 2004):

(a) Constructs required for production of goods and services (e.g. buildings, ports, rail, mines)

(b) Plant and machinery required for production (including the obvious high-tech components such as IT, software and telecommunications)

(c) The raw materials and components used in production that eventually results in consumer goods and services.

Innovation in capital goods, particular those described under (a) and (b) are of vital importance for the future prosperity of Australia. Solutions for managing water, infrastructure, telecommunications, and capital goods that support the production of goods and services will be underpinned by innovation in the capital goods sector. ‘Complex product systems’ (also called CoPS) is one particular class of capital goods that has been shown to be highly innovative. CoPS are high-cost engineering-intensive products, systems, networks and constructs (Davies and Hobday, 2005). In Australia, we can point to innovations in high-speed catamaran design (i.e INCAT and Austal Ltd) and air-traffic control systems, which imply that CoPS can be radical innovations that are just as significant as better publicized innovations in pharmaceuticals or IT.

The primary problem is that this type of innovation just doesn’t register on our standard measures of innovation performance and therefore becomes neglected as a focus for industry policy and management.

An overview of innovation in CoPS

CoPS have been shown to be a significant contributor to the UK economy. One review by Acha et al. (2004) showed that CoPS share of UK GDP for total manufacturing and construction was close to 19% in 1999. These businesses employed 1.2 million people at nearly double the average wage of other non-CoPS firms in the manufacturing and construction sector. The study used three tests to classify CoPS businesses. These were (1) high unit costs, (2) low volume and (3) a high degree of customization. These three features signal a departure from conventional thinking on innovation that is based on manufacturing and 1960s innovation models where inventions proceed down the commercialization pathway to become successful products.

In CoPS businesses, the model of innovation that begins with R&D that results in a discovery or invention that is then commercialized by mass manufacturing or licensing is quite meaningless. CoPS businesses continually innovate as part of the customization requirement. Much of this innovation can be classified as incremental but some CoPS firms routinely achieve breakthroughs in design. For example, Dodgson et al.’s (2007) case study of international engineering company ARUP and their revolutionary design for elevators that can be used to escape fires is a good example of this. Also, because this innovation is continuous and embedded in the customized solution process, the usual innovation measures of patents and R&D expenditure do not fully capture the innovative activity of these companies. While many manufacturing companies will protect their intellectual property with patents, CoPS companies can use product complexity to protect IP from replication by competitors. For example, McGaughey et al.’s (2000) study of INCAT showed that large high-speed catamarans were continually evolving in design as a way of responding to the next customer’s needs. Complexity and continual development meant that patents were not required to protect IP.

Anyone ranking the innovativeness of these CoPS companies using the standard measures of patents and R&D would conclude that these businesses were not an important contributor to the Australian innovation system. This is highly misleading and contributes to policy that does not recognize the importance of innovation in this economically significant category of firms.

System Integrators, CoPS and Project-based innovation

Many CoPS businesses evolve to become systems integrators where the expertise in designing and coordinating complex capital goods becomes the focus of the company’s competitive advantage. In these cases, the businesses become pure service providers. An example of this type of business is the renewable energy company Roaring 40s that evolved out of the Tasmanian Hydro Electric Commission. Roaring 40s is currently involved in a very large wind-farm joint venture in China, even though the physical components of the wind-farm will be provided by the joint venture partner and other suppliers.

Not all CoPS become systems integrators and many, like INCAT, retain a significant proportion of component and construct production in-house. Also, there are some businesses that are not truly CoPS but still have a significant part of the business organized around project-based production of CoPS-related capital goods such as constructs, plant and machinery. In Australia an important example of this is the resources sector. While these firms produce commodities such as gas, coal, iron ore and copper there is a significant component of innovation in the design and management of mines and oil fields. For example, Rio Tinto would be regarded as a consumer rather than producer of innovations. However, an internal report into knowledge sharing and innovation commissioned by Rio Tinto Coal Australia showed that production processes were being made more efficient by searching and recombining the expertise that was distributed among the several hundred employees (Rio Tinto, 2007). Interestingly, Rio Tinto uses a world-wide online expert forum to support the interaction that stimulates innovation. For Rio Tinto, this is a highly significant source of value-creating innovation, but it does not register on measures of new products, patents or R&D expenditure.

We need to pay a lot more attention to innovation in the capital goods economy. ‘Sexy’ industries like biotech and IT are important, but do not address the critical future challenges of energy, water and transport.

One the things that makes the current state of the music and newspaper industries so frustrating is that there are many steps that could have been taken to prevent these outcomes. It was not inevitable that their business models had to be destroyed by the internet. One of the questions that came up in the last meeting of the Brisbane Innovation Network was ‘how do you sell innovation internally if things are going pretty well for your company?’ I’ve thought about this a fair bit since that meeting, and I think that part of the answer is to extend your planning horizon.

The point that was being made is that his firm is in a stable industry, they’re doing well right now, and things are looking good into the future as well. So why do they need to innovate? I think that if there is not an especially strong incentive to innovate now, that makes it a pretty good time to start thinking about what is going to make your industry or firm obsolete. As Clay Shirky dicusses in an outstanding essay on the current state of play for the newspaper industry, there was a time when things seemed pretty stable in that industry as well. Consequently, none of the major players seemed equipped to adapt when things started to change. Shirky outlines how in many cases people simply refused to believe that change could occur. I think this holds lessons for firms in industries that seem stable now. Don Tapscott suggests that higher education may well be facing a similar situation soon, and there are probably plenty of other firms and industries that should be thinking about these questions sooner rather than later.

So what should you do? Steven Johnson gave a speech at SXSW the same day that Shirky’s post appeared, and he has some excellent suggestions. He talks about ways in which the industry might evolve, and where the opportunities may lie. He focuses on how a disntermediated news industry might look, and stresses the idea that there will be opportunities to develop new profitable business models in several of these areas. There’s no reason that newspapers can’t take advantage of these opportunities themselves – in fact, in many areas they still have built-in advantages. Johnson may well have the beginnings of a general model of information-based industries making a transition into the digital age.

In light of all of this, my answer to the original question is: if things seem good now, then it’s time to start planning for whatever it is that will put you out of business. All innovations that fuel economic growth and change at their most basic level are information. We’re seeing more and more examples of what happens when it becomes easier to make and share digital copies of information. It’s time to learn from the experience of the newspaper industry. Instead of insisting that things will be different for you, it will be much more useful to ask ‘how can this work for me?’