In part II of this blog series, I stated:

Innovation, imitation, and the thundering herd of entrepreneurship are what propel virtually all competitive industry clusters. While the success of an individual firm may depend on its ability to protect its own technological advances, new products, or designs, the success of a cluster depends on the opposite: knowledge diffusion (through access to new innovations and information, and spin-offs of new enterprises). Clusters force competing members within the cluster to continually improve and innovate in order to maintain their advantages over imitators. Organizations live or die by their corporate strategy and their ability to innovate.

Over the past decade, there has been much talk and general agreement about the importance of innovation in our economy. No one argues that it is crucial for propelling American business forward and ensuring an enterprise’s competitive advantage on the global economic playing field. Yet there has been little discussion or insight on how to stimulate it. This must change. The majority of important, economy-enhancing innovations are generated by mid-market businesses. The problem lately is that many of these businesses have been too busy just trying to survive, let alone drive innovations to market as swiftly and often as possible.

With this blog I want to help change that. I want to help drive innovation and improve its foundations in a healthy commercial environment. I’ll delve into operational factors that, once improved through regional cooperation and collaboration, can enhance the underlying conditions we need for accelerated commercial innovation and sustained competitive advantage, for individual enterprises, their industrty clusters and the region as a whole.

Here’s the fundamental problem I want to address: Innovation and growth require capital. For any firm, the lowest-cost capital is cash flow from operations. But the economic inefficiencies of transaction management create competitive pressures for the firm in the form of price and margins; these in turn inhibit its ability to maximize cash flow from operations and limits its access to external capital sources. Lack of such capital naturally limits the growth of the firm, the industry cluster in which it participates, and the region-at-large.

First, Some Edification: In my last post in this series, I described three types of knowledge workers: tacit, transformational, and transactional. Now let’s build upon this by defining two types of knowledge: explicit and tacit.

1. Explicit knowledge can be shared or gained through written means, without interpersonal interaction.

2. Tacit knowledge is typically disseminated through personal or social interactions and is not easily expressed in writing. Interestingly, a person may not know that he or she possesses tacit knowledge until called upon to use it.

I also said that today's most valuable workers engage in business activities that economists call “interactions." The broadest definition of an interaction is the searching, coordinating, and monitoring that are required to exchange goods or services. Complex interactions typically require workers to make informed decisions or educated guesses with ambiguous information. These people (such as administrators, doctors, engineers, judges, lawyers, managers, mediators, nurses, salespeople, etc.) often need to draw upon their tacit knowledge.

All commerce is facilitated through communication. In this sense, you can think of communication as a confluence: the convergence of tacit knowledge, complex interactions, and transactions. Strategic options reside within communication of complex interactions among multiple systems. Formal and informal communication among those who hold tacit knowledge can bring new insight and understanding to a firm or economic region in ways that significantly shape strategic thinking and future success.

An illustrative example is multi-party transaction management for processing payments related to products or services. A typical transaction management approach involves the automatic processing of payments to multiple parties with payment chains extending through intermediary sellers. In some instances, an intermediary seller contracts with a buyer for goods and/or services, and further contracts with one or more performing sellers (e.g., suppliers) for the provision of the goods and/or services. In these instances, funds designated to the buyer (e.g., from a buyer's account or credit line) are transferred to the performing seller or parties in a manner commensurate with the contract between the intermediary seller and the performing seller or sellers. Additional funds are transferred from the buyer to the intermediary seller commensurate with the contract between the buyer and the intermediary seller, less any amount paid to the performing seller or sellers for a particular transaction or event.

Here’s a familiar example of an enterprise that engages regularly in such multi-party transactions: Ticketmaster. Ticketmaster is an intermediary seller who has multiple contracts with the buyers and sellers of services. The individual buyer, who is attending a concert; the venue, that is both a buyer and intermediary seller of the provisioned services; the promoter, who is another intermediary for the performing seller; and the performing seller, the band putting on the concert. In this example the only party who has visibility to the knowledge across multiple systems is Ticketmaster. They are the only party that knows what acts are performing at what venues when, what inventory (seats) is available, and for how much.

Regional Industry Clusters Could Learn a Thing or Two from Ticketmaster

There is an inherent opportunity surrounding the management of multi-party transactions. The innovation that is Ticketmaster dramatically lowered transaction costs and increased margins for the thousands of businesses participating in the industry’s multi-party transactions. This in turn frees up capital, time, and human resources among those businesses, making them more flexible and responsive to changes in the marketplace. They have the room to become more innovative themselves.

How does this relate to innovation and regional prosperity? This is how: Most regions have not realized that economic organization can be proactively managed through an appropriate mix of contracting activities and technology infrastructure. For our purposes -- to drive prosperity within a region -- we need such a model of regional collaboration that encourages sufficient innovation to support emerging and growth industry clusters. Policies formulated by individual firms or industry sectors alone are not sufficient to overcome region-wide deficiencies in cluster development. Public sector and economic development policy and strategy must be married to industry policy if clusters are to grow and prosper within a region.

So, we’re going to talk about the elements of effective business and organizational management that can directly impact an industry cluster’s capacity for sustaining innovation and competitive advantage. These include:

• Improving the sharing of tacit knowledge and regional understanding of complex interactions through strategic thinking, rather than strategic planning

• Organizing business processes and managing transaction costs to improve economic organization and drive industry cluster development

• Recognizing and managing patterns of inter- and intra-firm transactions and the relationships that propel them

• Leveraging technology infrastructure to free up time and capital by supporting complex interactions, transactions, and contract management

1. Improving the sharing of tacit knowledge and regional understanding of complex interactions through strategic thinking, rather than strategic planning

Strategy is typically viewed as the pursuit of business outcomes, rather than a process unto itself. But have you noticed that many successful entrepreneurs have ignored conventional strategic planning processes? I think one reason for this trend is that to plan strategically you must assume a linear activity based on connecting past, present, and future performance in a stable environment. As I suspect you know, the nature of today’s dynamic business environment is anything but! It’s no wonder that many organizations have abandoned strategic planning.

Instead, today’s more innovative firms have replaced strategic planning with strategic thinking. This is a shift to a process-based view of strategy.

Strategic thinking involves the search for emerging patterns of system interactions not previously apparent or obvious. These patterns of interactions can be leveraged by a firm -- or a region -- through the application of resources within the firm’s or region’s environment. This is why you’ve been hearing such buzz-phrases as core competencies and the resource-based view of the firm in today’s business lexicon.

To initiate an organizational or regional shift to such a process-based view of strategy, I encourage business and regional leaders to focus on the processes inherent in tacit knowledge interactions and resulting transactions. This can be your first step toward developing and implementing a regional strategy that supports the formalization of a sustainable competitive position for your region and its industry cluster firms. Encouraging more efficient and effective sharing of tacit knowledge and related complex interactions is a practical means for bringing structured mechanisms to formalize innovation and transactions which drive regional prosperity.

2. Organizing business processes and managing transaction costs to improve economic organization and drive industry cluster development

Business organizations can realize competitive cost advantages through organizing production and transaction exchange. Through the appropriate structure of activities, relationships, and complex interactions between firms, businesses can stimulate important strategic decisions in organizational innovations. As with Ticketmaster, history is abundant in examples in the role of organizational innovations contributing to the success of particular businesses and industries. Understanding why businesses organize as they do is important for the development of sound public policies towards economic organization and stimulating economic activity.

Transaction cost economics, a subset of institutional economics, is a body of research that explains the perspective of contracting and economic organization arrangements adopted by societies and business to govern economic activity in the pursuit of competitive advantage and wealth. The central tenet of transaction cost economics is simply that business will adopt the most efficient and lowest cost transaction alternative available to them.

The problems of economic activity organization always arise wherever the benefits of economic specialization lead to trade. Industry cluster development is no different. Trade requires the need to coordinate complex interactions and transactions. As long as there are profits to be had from trade, the parties involved have an incentive to coordinate and collaborate.

Transaction costs can best be defined in terms of such activities as bargaining, contracting, and monitoring of performance; in other words, activities in which they engage as a consequence of the need to coordinate activities among buyers and sellers. These activities are not directly related to production.

Excess transaction costs can be attributed to two types of human nature:

1. Individuals who intend to act in a rational manner but are hampered by their limited knowledge, foresight, skill, resources and time.

2. Individuals who have a propensity to behave opportunistically. This behavior includes the willingness to renege on promises, cheat on agreements, ignore ethical responsibilities, circumvent rules, search out loop holes, or otherwise exploit vulnerabilities of a trading partner to gain economic advantage.

In either case, excess transaction costs depress economic activity and the firm’s or region’s capacity for innovation. To accelerate industry cluster development, business and regional leaders need to match organizations through properly aligned and structured interactions and transactions, governed by appropriate structures and competencies which focus on cost management.

How can you positively influence the dynamics of the two types of human nature described above? Certainly, businesses have formal codes and norms of behavior that can be enforced through the authority we ascribe to our institutions and organizations. I also want to encourage readers to also pay special attention to informal social networks. These social networks are extremely capable of creating transaction rules that establish norms and standards for individual behavior within the group, while clarifying the risk of being ostracized for violations by said group. When it comes to pursuing and maximizing interacting firms’ shared economic objective -- that is, wealth -- informal social networks must be embraced and proactively managed.

3. Recognizing and managing patterns of inter- and intra-firm transactions and the relationships that propel them

Inter-firm transactions are a firm’s explicit and implicit contracts. They consist of the firm’s assets and mechanisms to handle information, manage risks, and exert control. Intra-firm transactions are consolidated ownership of these organizational assets in the hands of one firm in service to multiple firms. Vertical integration of these assets allows for flexibility in economic activity, along with cost containment and economies of scale associated with transaction costs that are not directly related to production.

Vertical integration and transaction cost considerations in the development of a firm’s or region’s skilled labor has important ramifications to the competitive market position and prosperity of each. Acquiring transaction-specific knowledge comes with high switching costs. It is not easily transferable and, as such, it is a source of sustainable competitive advantage when combined with economies of scale. Know-how and cost structure cannot simply be transferred from supplier to supplier like an operations manual. High switching costs combined with first-mover advantage holds the greatest opportunity for regions, their industry clusters, associated firms, and skilled labor to erect competitive barriers and achieve prosperity.

With our focus on maximizing the opportunities inherent in sharing tacit knowledge and facilitating complex interactions, stimulating innovation logically requires investment in relationship management capability. The structure of vertical relationships between buyers and sellers is strongly affected by the importance of the relationship, and the investment they collectively put into the relationship in pursuit of their joint wealth.

Strategic thinking is an exercise in understanding tacit complexity -- a combination of tacit knowledge, complex interactions, and transaction management. Pattern recognition is dependent upon the definition of complex interactions which requires strategic thinking combined with tacitly-held knowledge of multiple systems across firms. Entrepreneurs holding such tacit knowledge are often able to detect emerging patterns that are not obvious to the casual observer. But because this detection ability is based on tacit knowledge, these entrepreneurs are equally as often unable to communicate these patterns to others.

The ability to recognize and communicate patterns of complex interactions and transactions across systems is complicated further because communities of practice rarely extend beyond their own system boundaries. For example, in the business world the supply chain associated with one finished product may contain hundreds or thousands of components, manufactured in several countries by a hundreds of manufactures and sold to thousands of end-users. And because tacit knowledge is often isolated in one person, one system, or another, significant interactions across multiple systems often go unobserved.

Thus, the ability of the individual firm to pursue the internalization of this transaction management approach is cost prohibitive and not probable. The investment and administrative burden in activities which are not directly related to the firm’s production and which are not strategic to the firm are given the lowest priority by management. Management has a strong disposition toward external sourcing of non-core activities because of cost, time, and risks. Acquiring the skilled labor, technology, knowledge, equipment, and facilities creates traditional business risks associated with uncertainty that an individual firm cannot adequately address. The firm is left to absorb the economic inefficiencies of fragmented external solutions or existing internal capabilities.

This is why I think a regional approach to structuring complex interactions to take advantage of the coordinating properties of hierarchies and the ability of the firm to reduce costs and risks is a sound public sector policy pursuit.

In a sense, you could say that it’s time for regional leaders to start thinking strategically and facilitating relationships and economies of scale across their regions and industry clusters.

4. Leveraging technology infrastructure to free up time and capital by supporting complex interactions, transactions, and contract management

What if instead we started looking to technology and the automated analysis of which it is capable? In recent years, networking and data storage have been revolutionized by large-scale data collection methods, faceted classification, and categorization. Large knowledge repositories and databases are now available that store, sequence, structure, and map vast amounts of information that is not easily analyzed by humans.

The scale and nature of the available data has stimulated research in automated analysis methods and pattern recognition. Analytical methods have proven to be quite effective at processing vast amounts of market, competitive, and business data to create intelligence for informed decision making. Virtually all industry sectors have been impacted: financial markets, banking, insurance, manufacturing, transportation, logistics, and the supply chain.

Structured innovation mechanisms for tacit knowledge workers must be supported and leveraged to drive innovation. This requires that their time be freed from transformational and transactional work if they and their firms are to innovate and leverage the knowledge of multiple systems relevant to the existing and emerging industry clusters. Therefore, public sector and economic development policy for regions must embrace a strategy that includes the facilitation and acceleration of global commerce through the development and deployment of technology infrastructure to support complex interactions, transactions, contract management, and informal social networks because these activities are beyond the reach of most firms operating on their own.

While the post-industrial economy emerges and online markets continue to rapidly evolve, automation advances are required due to the complexities and business risks involved in commerce transactions. Today regions lack the critical capability necessary for managing complex interactions or online transactions. Innovation will continued to be driven by the skilled labor associated with tacit knowledge workers. Innovation mechanisms must be managed as part of public sector and economic development policy. (The Dubberly Design Office as part of a project at the Institute for the Creative Process at Alberta College of Arts and Design in Canada has developed what we consider to be an excellent model of innovation; see link.) Innovation Model

In Summary

To obtain regional value from complex interaction investments, regions must be able to monitor and support business transaction quality in a simple way that doesn't add to the complexity of the technology infrastructure. Complex interaction management promises to be sustainable basis for regional economic development policy. Competitive regions, industry clusters, and businesses require a technology infrastructure robust enough to audit, track, and trace transactions from beginning to end, examining how these transactions affect all parties, applications and systems they touch. Our objective must be to detect emerging patterns quickly -- before they adversely affect industry clusters, levels of service, or users’ experience.

Today most regions are struggling with their economic development policy. To move forward, they must creatively and cost-effectively brand their region based on existing and emerging industry clusters. Concurrently, they must raise awareness and understanding in the marketplace about tacit knowledge workers, complex interactions, and transaction management. They must be prepared to assume the region's logical and rightful role as a leader in this area. Understanding that clusters are of value to regions only matters if such knowledge leads to measurable actions that grow economies and raise standards of living. Successful efforts to leverage industry clusters and the complex tacit knowledge interactions which support them can generate sustainable regional competitive advantages. Regions that pursue this strategy with appropriate public and economic development policy can expect an increasing standard of living for its citizens.

Coming Soon: Encouraging Innovation and Competitive Advantage through Team-building