The Theory of the Innovative Organization by William Lazonick

An excerpt from William Lazonick’s terrific work “Business Organization and the Myth of the Market Economy”, a book that offers a critique of what a ‘market economy’ is purported to be, through an evaluation of the strategies and economic histories of businesses within what can be called “actually existing capitalism”.

Here, at the risk of a small amount of repetition, I shall supplement that discussion by focusing on the nature of fixed costs, the different sources of uncertainty the innovative organization faces, and the relation between organizational capability and technological change. Through its investment activities, a business organization commits financial resources to specific processes to make particular products with the expectation of reaping financial returns. Once they are committed, the productive assets of the organization represent fixed costs that must then be recouped by the production and sale of output. If, through the sale of sufficient output, investments could generate expected financial returns instantaneously, fixed costs would not represent an economic problem to the organization. But then, we would probably not call the “assets” underlying these costs “investments.” Indeed, we might not even deem it appropriate to call these costs “fixed” or the entity that incurs them a firm. The problem of fixed costs occurs because the production and sale of the enterprise’s output occur neither instantaneously nor with certainty. The basic economic problem that confronts the capitalist enterprise is to transform fixed costs into revenue-generating products to realize financial returns. An analysis of how and with what success the business organization manages this transformation is the key to understanding technological change, value creation, and economic growth.

In making its investment decisions, the organization can choose to be either innovative or adaptive. The two distinct types of investment strategy have different implications for the role of the business organization in the generation of technological change and the creation of value. If the organization adopts an adaptive strategy, it need only combine human and physical resources according to well-known technical specifications in order to produce a saleable product at a competitive cost. When the organization chooses an adaptive strategy, it may increase the amount of human and physical resources applied to productive activity - it may add to its capital stock. But unlike the innovative organization, the adaptive organization does not enhance the productive capabilities of these resources. In contrast, if the organization chooses to adopt an innovative investment strategy, it must develop its productive resources in order to produce a superior product at competitive cost (product innovation), a saleable product at lower cost (process innovation), or both.

In choosing an investment strategy, the central economic problem facing the decision maker is the uncertainty of realizing a financial return. When undertaking productive investment, incalculable economic uncertainty cannot be avoided precisely because technology and the structure of the economy are constantly in the process of evolution. But the presence of economic uncertainty - the possibility that a particular investment will fail - should not be viewed as simply a costly economic problem; for if innovation is wanted, it is paramount that, far from seeking to avoid uncertainty, business organizations seek to confront it. The innovative strategy represents an attempt to confront economic uncertainty, the adaptive strategy an attempt to avoid it.

In making investments, there are two qualitatively different types of economic uncertainty that an organization can face: productive uncertainty and competitive uncertainty,¹ The one type of uncertainty pertains to the internal operations of the organization, the other to the organization’s relation to its external economic environment.

Productive uncertainty is inherent in the unknown qualities of the product innovations and unknown productivity-enhancing impacts of the process innovations that the investment strategy is expected to yield. Once the processes and products have been successfully developed, moreover, the organization must elicit sufficient effort from its employees in order to achieve a high rate of utilization of its productive resources. Even when the skills, or productive capabilities, of the human resources that it employs are known, the organization cannot be certain about the extent to which employees will in fact exert productive effort, and hence put these capabilities to the service of the enterprise.² At issue is not just the productivity of labor, but also, insofar as the productivity of physical resources depends on human effort, the productivity of capital. Competitive uncertainty is inherent in the inability of the organization to know for certain the availability of factor supplies and the extent of product demands over the period during which it is trying to transform fixed costs into financial returns. Macroeconomic demand fluctuations may intensify interindustry as well as intraindustry competition for a more limited extent of the market. Within its own industry, moreover, even for a given level of product demand, the organization cannot know for certain what innovative strategies and competitive adaptations its existing competitors will pursue and what new competitors might come on the scene. When incurring fixed costs, therefore, the organization cannot know the extent of the market that it will attain and the unit costs that it will be able to achieve.

The more innovative the strategy that the organization chooses - that is, the more the enterprise must develop its productive resources to yield process and product innovations - the more productive uncertainty it faces. Unlike competitive uncertainty, productive uncertainty is not determined by the external environment but is a matter of strategic choice. And in contrast to the innovative organization, the adaptive organization chooses to avoid productive uncertainty by investing only in those process and product technologies for which the required productive capabilities are known.

The adaptive organization can also try to avoid competitive uncertainty by shunning fixed costs, relying instead on variable costs - rented plant and equipment, spot versus bulk materials purchases, wage versus salaried labor, consultants and agents versus permanent staff and facilities. The adaptive organization seeks to minimize competitive uncertainty by minimizing its fixed commitments. If the organization could produce solely on the basis of variable costs, there would be no productive or competitive uncertainty for the simple reason that the enterprise would not be making any investments from which it might expect a return.

But insofar as fixed costs are unavoidable — and in the real world even those items that we generally call variable costs do not generate revenues instantaneously - the adaptive organization cannot completely avoid economic uncertainty. Although (by definition) the adaptive organization does not have to develop the productive capabilities of its resources, it still must utilize them, and hence faces the productive uncertainty of how much effort it will be able to elicit from its employees. It also faces competitive uncertainty because of the ease with which other organizations can produce the same saleable products at the same competitive costs. In an industry made up of adaptive organizations, the unpredictable anarchy of the market — the uncoordinated nature of the demand for factors of production and the supply of products in an industry characterized by easy entry and relatively small enterprises - may lead the investing enterprise (and indeed each competing enterprise) to experience not only lower product prices than had prevailed when it made its investments but also higher unit variable costs and higher unit fixed costs. The lower product prices may result from the well-known phenomenon of cutthroat competition: uncontrolled price cutting in the face of overproduction. Higher unit variable costs may result because of ’excess’ demand for factors of production (i.e., in excess of what the enterprise had expected when it made its investments). Such excess demand subjects the organization not only to higher factor prices but also, in the case of wage labor, to a workforce whose supply of effort, and hence productivity, is more difficult for the organization to control. Higher unit fixed costs may result because of the organization’s inability to utilize its productive resources as it expected and attain its anticipated market share.

The adaptive organization also faces the competitive uncertainty that an innovative organization might enter its industry and succeed in producing a superior product at a lower cost. But in the competition between adaptive and innovative organizations, competitive uncertainty cuts both ways. The presence of adaptive organizations in an industry also creates competitive uncertainty for the innovative organization because its investment strategy invariably entails higher fixed costs than the adaptive strategy. An innovative strategy requires that the organization invest in, and develop in a simultaneous or coordinated fashion, a number of vertically related (even if technologically separable) productive activities. The innovative organization, that is, must be more vertically integrated than the adaptive organization.

It is not only vertically related investments in plant and equipment that increase the fixed costs of the innovative organization. To generate new technologies, the innovative organization must invest in specialized research and development facilities. To determine the needs of potential buyers, the innovative organization must also invest in specialized marketing facilities. And to plan and coordinate development, production, and marketing activities, the innovative organization must make further fixed investments in a managerial bureaucracy.

At low levels of capacity utilization, the innovative organization, with its high fixed costs, incurs higher unit costs than does the adaptive organization. If it can achieve high levels of capacity utilization, the innovative organization may be able to outcompete its less capital-intensive rivals. But the relatively low fixed costs of adaptive organizations may impede the innovative organization from actually gaining sufficient market share to achieve lower unit costs. The innovative organization, moreover, faces the distinct possibility that, in response to its innovative strategy, adaptive organizations will compete by accepting lower profits, running down their capital stock, using inferior materials, and extracting wage concessions and greater effort from their workers. The possibility of such adaptive responses increases the competitive uncertainty facing the innovative organization, laden as it is with fixed costs. Hence, when an organization chooses an innovative strategy, it confronts productive uncertainty and in so doing may also expose itself to competitive uncertainty. But by its very choice of investment strategy, the innovative organization also undertakes to develop the productive potential for shaping and controlling - that is, managing - its economic environment in ways designed to ensure the economic success of its innovative strategy. To manage its economic environment, the innovative organization must complement its investment strategy with an appropriate organizational structure. Indeed, to pursue an innovative strategy without building an appropriate organizational structure is to confront economic uncertainty without creating any means to overcome it.

An appropriate organizational structure enables the organization to manage two distinct stages of the value-creation process: the development stage and the utilization stage. The passage through these stages to financial success does not happen just because investments in productive resources have been made. Rather, success comes from planning and coordinating the development and utilization of the organization s investments. Some of the productive resources in which the organization invests are plant and facilities, but others are personnel.

Investment in a managerial bureaucracy is critical because it enables the organization to develop the enterprise-specific organizational capability that is in turn required to plan and coordinate its physical resources and technical personnel. By transforming previously unknown technologies into process and product innovations that are ready to be utilized, organizational capability overcomes productive uncertainty. On the basis of the organizational capability that it has developed, the organization continues to overcome productive uncertainty by utilizing its productive capacity sufficiently to achieve low unit fixed costs while controlling the rise of its unit variable costs.

But why does the innovative organization need organizational capability to ensure the success of its investment strategy? To answer this question we must pose yet another: Why does technological change enable the organization to produce superior products at lower costs? Technological change overcomes the productive limitations that the skill and effort of human beings had previously placed on the transformation of inputs into outputs. By displacing the human skills and saving on the human effort required by a previous technology, technological change enables the organization to produce a superior product at a lower cost. In more general terms, it enables the organization to raise physical productivity. But to achieve this productive benefit, technological change requires the expenditure of productive resources on the development of new types of skills as well as the utilization of the efforts of those who come to possess those skills.

The more technologically complex the innovation, the greater the need for innovative skills and the more extensive the specialized division of labor required to develop and utilize these skills. The organization must not only develop these specialized skills so that they can contribute to the innovation, but also coordinate them so that they constitute a collective productive power. Organizational capability permits the enterprise to plan and coordinate the development of these innovative skills, integrating them into an enterprise-specific collective force. As far as the innovation process is concerned, therefore, organizational capability permits the planned coordination of the horizontal and vertical division of labor required to generate an innovation.

But even when an innovation has been generated, the organization must attain a large market share in order to transform its high fixed costs into low unit costs. To do so, it must invest in production facilities with sufficient capacity to supply a large market share, thus further increasing its fixed costs. To overcome the potential competitive disadvantage inherent in its high fixed costs, the innovative organization must use its organizational capability to plan and coordinate the utilization of the productive resources at its disposal. In particular, the organization must speed the flow of work through its vertically related production processes, so that high fixed costs can be spread out over the largest possible volume of output in the shortest possible period of time - hence Chandler’s focus on throughput and economies of speed.

It is the effort-saving nature of technological change that creates the potential for achieving high throughput on the basis of given production facilities: the speed of the work flow can increase without necessarily requiring more effort from workers. But it is the organizational capability of the enterprise in coordinating the efforts of those involved in the organization’s vertically related processes that transforms the potential into actuality.

The need to increase throughput to achieve low unit costs exposes the innovative organization to new sources of competitive uncertainty. The supply of inputs and the sale of outputs cannot be left to the market. As the volume of throughput expands, pressures build for the organization to integrate backward into material supplies to ensure the high-volume flow of inputs of requisite quality necessary to maintain the high throughput, which is in turn necessary to supply a large enough extent of the market to transform high fixed costs into low unit costs. Similarly, pressures build for forward integration into mass-distribution facilities in order to ensure the aggressive marketing of the organization’s output required to transform mass production into mass sales.

As a result of such backward and forward integration, dictated in this case by the need to achieve high levels of resource utilization rather than superior resource development, the organization transforms what were previously variable costs into fixed costs. As a result as well, the organization transforms competitive uncertainty, inherent in its reliance on the market (the essence of variable costs), into productive uncertainty, inherent in its reliance on the organization (the essence of fixed costs). By virtue of its strategy of forward and backward integration, however, the innovative organization has not simply replaced one type of uncertainty by another. Rather, by converting variable costs into fixed costs, the organization transforms uncertainty into a form over which, by relying on its own organizational capability, it can exercise more control. All the more pressure is put on organizational capability to plan and coordinate the internal division of labor in order to transform high fixed costs into low unit costs.

Once the innovative organization has captured sufficient market share to ensure the success of its investment strategy, organizational capability provides the institutional foundations for entry into new product markets. The organization’s investments in systematic research and development facilities enable it to generate product innovations that create opportunities for spreading out some of its existing fixed costs over a number of technologically related product lines. As the organization undertakes these new investment strategies, it expands the scope, as distinct from the scale, of its innovative endeavors.³ But economies of scale remain critical. To transform these new strategies into competitive advantage, the organization must, as in the case of its previous investments, develop and utilize the resources that it commits to each of its new product lines in ways that generate superior products at low costs.

Innovative organizations that choose to make investments in those technologically complex industries characterized by high levels of productive uncertainty will face a greater chance of failure but also the opportunity of gaining significant market power if the innovative strategy succeeds. Once the organization has gained a large extent of the relevant market, moreover, it can use its dominant position to enlarge its market share and sustain its competitive advantage - hence the phenomenon of oligopolistic market power. Generally speaking, the greater the innovative effort undertaken, the greater the market share the organization will have to secure to achieve economic success and the greater the possibility for those organizations that move first in investing in innovation to secure an oligopolistic position.

Even when the technical characteristics of the once-new processes and products become well known, later movers still face a degree of productive uncertainty because of the need to develop enterprise-specific organizational capability in order to implement the technological change. Even if the market can supply the organization with individual personnel with the appropriate skills and attitudes, it takes time and the commitment of resources to integrate the activities of these individuals into the organized force that constitutes the essence of organizational capability. Meanwhile, in what Schumpeter called the process of creative destruction,⁴ the incumbent oligopolist may use its already developed organizational capability to undertake new innovative investments that make its own past technological successes obsolete, thus increasing the competitive uncertainty facing later movers. Furthermore, later movers face competitive uncertainty because the incumbent organizations already possess the large market shares, and they do not. To fight off the challenges of later movers, the incumbent oligopolist may use its market power to pursue an adaptive strategy of predatory pricing on the basis of its existing technological capability.

In other words, with the emergence of oligopoly, it becomes increasingly difficult for later movers to choose a strategy that avoids fixed costs. If they want to challenge the power of the first movers, they must confront uncertainty by making innovative investments in technology rather than try to adapt by imitating those strategies that have made the first movers successful in the past. Whatever the entrepreneurial drive, productive talent, and financial resources available for employment in a particular economic environment, the existence of oligopoly may render the economic uncertainty facing later movers so great that attempts to enter the industry are simply not made.

Innovative success can therefore free the oligopolistic organization not only from productive uncertainty but also from competitive uncertainty. Precisely because it has overcome uncertainty by the development and utilization of its productive resources, the oligopolistic enterprise finds itself in a position to become a truly adaptive organization. It possesses considerable assets, but because it is realizing a steady flow of revenues on the basis of these past investments, it no longer faces the economic problem of fixed costs. By living off its capital, the oligopolist may be able to remain profitable for years on end, even if it makes no new investments of any kind; all the more so if it adopts a strategy of disinvestment that enables it to reap financial returns with no allowance for replacing its depleted productive resources. Rather than confront uncertainty by undertaking new innovative strategies, the oligopolistic organization may choose a comfortable existence that avoids uncertainty. The very success of the organization in overcoming productive and competitive uncertainty may create the market conditions that encourage it to turn from innovation to adaptation.