1

Evolutionary Perspectives on Firms’ Internal and External Portfolios of New Capabilities

Gurneeta Vasudeva

University of Minnesota

3-365 Carlson School of Management

321 19th Avenue South

Minneapolis, MN 55455

Phone: (612) 625-5940

Email: gurneeta@umn.edu

Jaideep Anand

Fisher College of Business

Ohio State University

2100 Neil Avenue

Columbus, OH 43210-1144

Phone: (614) 247-6851

Email: anand.18@osu.edu

Version: November 1, 2015

(Submitted to Strategy Science Special Issue)

2

Evolutionary Perspectives on Firms’ Internal and External Portfolios of New Capabilities

Abstract

Received wisdom from evolutionary theory and behavioral approaches yields potentially heterogeneous

search pathways for firms under uncertain conditions. On one hand, the need for experimentation under

uncertainty propels firms to initiate a broad-based search, followed by the selection and retention of a

narrow set of capabilities as learning occurs. We label this search pathway as ‘outside-in’ wherein variety

is followed by focus. On the other hand, behavioral assumptions of cognitive constraints and routines

point to a focused set of capabilities, which broaden as firms build absorptive capacity over time.

Moreover, path dependence can render the search process inflexible making selective retention more

difficult. We label this alternative search pathway as ‘inside-out’ wherein focus is followed by variety.

We find support for these two alternative search pathways in a radical technological context: ‘inside-out’

and ‘outside-in’ characterizing firms’ internal and external portfolios of capabilities, respectively. We

reason that as learning occurs, firms’ internal portfolios are reconfigured less easily relative to external

portfolios constituting more loosely coupled arrangements such as alliances. Our theory and empirical

findings hold important implications for understanding firms’ technology strategy and innovation

performance in an evolving technological context.

3

Introduction

How do firms configure, adapt, and modify their capabilities in new and emergent contexts? To address

such issues, evolutionary theory based reasoning has pointed to the importance of a learning orientation

aimed at innovation and improvements upon the steady state (Nelson and Winter 1982). As Nelson

(1994:111) observed, for firms facing uncertainty in any given knowledge domain, “good responses…are

still to be learned.” Consequently, evolutionary theory suggests that confronted with alternative

approaches and solutions, firms initialize their search through variation-seeking and experimentation

because such an approach allows for flexibility for reconfiguration as firms monitor the developments in

the industry. Over time, as firms learn and gain experience, a winnowing process occurs resulting in the

retention of only the most relevant knowledge. Based on these mechanisms of variation, selection, and

retention, evolutionary theory predicts an ‘outside-in’ pathway for firms’ search characterized by

increasing diversity followed by more focused approaches.

Although the evolutionary model of variation-selection-retention offers important insights for

understanding the pattern of search, behavioral continuity manifested in cognitive constraints and

organizational routines (Cyert and March 1963, Levitt and March 1988, Levinthal and March 1993),

yields a different pattern of search. According to this reasoning, firms’ search is initialized by focused

investments, and any increase in breadth becomes possible only to the extent that firms build the

commensurate absorptive capacity. Moreover, contrary to the winnowing mechanism, this behavioral

approach emphasizes path dependencies that make it difficult for firms to reconfigure and get rid of

competencies once these are added to a firm’s repertoire. In other words as Nelson and Winter (1982:

134) observed, “firms may be expected to behave in the future, according to the routines they have

employed in the past.” Based on this logic, firms’ capabilities are likely to grow ‘inside-out’.

Thus, while evolutionary theory based reasoning is useful in offering solutions and identifying

constraints to the problems of uncertain and emergent contexts, incorporating the role of cognitive

constraints and path dependence could generate alternative pathways, suggesting therefore, that

4

evolutionary theory may be underspecified. Based on these dual perspectives, we ask the question: do

alternative pathways for building new knowledge and competencies coexist or is there a unique path?

Our goal in this study is to develop and empirically test the implications of evolutionary theory

applied to firms’ internal and external portfolios in an emergent technological setting. Given the

important consequences of new capabilities, especially in the context of radical and uncertain

technological shifts (Henderson and Clark 1990, Nagarajan and Mitchell 1998, Tripsas and Gavetti 2000),

understanding their evolutionary path over time becomes a crucial research question. We propose two

distinct evolutionary processes and argue that they apply differentially to the configuration and

reconfiguration of internal and external portfolios of technological capabilities. We test our hypotheses

using data on the technological diversity of firms’ internal portfolios comprising fuel cell technology

patents produced by firms’ R&D units, and their external portfolios characterized by the fuel cell

technology patents held by their alliance partners, over the period 1981-2004. Fuel cell patents can be

categorized into technological areas that represent the various types and components of fuel cells. The

diversity of firms’ patents therefore, conveys important information about whether firms are

simultaneously developing multiple capabilities or focusing in a few areas.

We find that the evolution of internal portfolios is characterized by an approach which we label

‘inside-out’ whereby focused competencies expand into a broader set of capabilities as the firm builds

absorptive capacity over time. At the same time, internal portfolios are slower to reconfigure implying

that embedded routines and path dependence limit the winnowing process. In contrast to internal

portfolios, the external portfolios evolve ‘outside-in’ which conforms to the more classical prediction of

greater variation in the initial stages, and subsequent reconfiguration through the selection and retention

mechanisms. We suggest that such a path is enabled by loosely coupled inter-organizational arrangements

that lend themselves to experimentation and selective retention as learning occurs. Our findings reveal

that firms may use their internal and external portfolios strategically to counterbalance each other, such

that a greater degree of variation in one is offset by a greater degree of focus in the other, and one is

subject to faster reconfiguration than the other.

5

Theory and Hypotheses

There exists an array of theoretical perspectives on firms’ ability to reconfigure or modify their resources

and capabilities to sustain competitive advantage. On one end of the spectrum, a resource-based

perspective views firms as bundles of capabilities which create value to the extent that the underlying

resources tend to be durable and are not easily replicated or redistributed (e.g., Wernerfelt 1984, Barney

1991, Priem and Butler 2001), leaving firms with few alternatives other than governance mechanisms

rooted in transaction cost economics (Williamson, 1991), to protect and coordinate existing resources and

capabilities. At the other extreme, population ecology argues that firms are fundamentally incapable of

engineering a resource reconfiguration. Instead, in this ecological perspective, change is accomplished at

the population level by organizational birth and death (e.g., Hannan and Freeman 1984, Haveman 1992).

Our approach takes an evolutionary view which resides somewhere in between these contrasting

perspectives concerning firms’ adaptation to a changing environment (Nelson and Winter, 1982). It

emphasizes the ability of firms to reconfigure their portfolios of capabilities, albeit, in a ‘Lamarckian’

sense, limited by cognitive constraints, organizational routines and path dependence. Such a skill

constitutes a dynamic capability which refers to “the firm’s ability to integrate, build, and reconfigure

internal and external competences to address rapidly changing environments” (Teece et al. 1997: 516) and

sustain competitive advantage (Helfat and Peteraf 2003, Helfat et al. 2007).

Alternative evolutionary pathways: ‘outside-in’ and ‘inside-out’

When competing in a new and emergent context, firms are usually faced with a considerable amount of

uncertainty stemming from various unknowns. For example, in the context of technological change, oft