Exploitation and exploration dynamics in recessionary times

B. Walrave

Research output: ThesisPhd Thesis 1 (Research TU/e / Graduation TU/e)

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Abstract

Firm performance largely depends on the ability to adapt to, and exploit, changes in the business environment. That is, firms should maintain ecological fitness by reconfiguring their resource base to cope with emerging threats and explore new opportunities, while at the same time exploiting existing resources. As such, firms possessing the ability to simultaneously perform exploitative and explorative initiatives are more resilient. In this respect, the performance implications of balancing exploitation and exploration activities are well documented in the literature. Especially the benefits of this balancing act in non-crisis contexts are increasingly better understood. However, far less is known regarding this capability during times of economic turbulence, despite the fact that such periods form a primary cause of organizational failure. Moreover, much has been written about the importance of the exploitation-exploration combination for firm performance, but getting it ‘right’ appears to be particularly difficult for many firms. These observations constitute the raison d'être for conducting this doctoral thesis. As such, this dissertation aims to investigate how firms should orchestrate their exploitation and exploration activities in recessionary times. Firms spent at least 35 per cent of their time in contexts of recession and subsequent recovery - for instance, the financial crisis that started around 2007. This is the focus of Chapter 2. A similar setting involves organizational crisis situations caused by shifts in the environmental context. These crisis situations can of course be (but not necessarily have to be) the result of an economic contraction to which to management did not adequately respond (focus of Chapters 3 and 4). As a result, three longitudinal studies are conducted, to advance the exploitation-exploration research field, particularly in the context of economic recession and recovery. As stated, the best course of action concerning the balance between exploitation and exploration investments during times of crisis is not understood very well. In this respect, it is not clear how times of recession and recovery influence the most profitable exploitation-exploration ratio, despite the fact these macroeconomic forces appear to influence firm performance to a great extent. This makes it paramount, for theory as well as for practice, that a better understanding is developed concerning the relationship between firm performance and the exploitation-exploration ratio. As such, the first empirical study of this dissertation, in Chapter 2, investigates what the relationship is between the exploitation-exploration ratio and firm performance in times of recession and recovery (i.e., bear and bull). This first study utilizes firm data from the most recent global economic recession (bear) and recovery (bull), to explore exploitation-exploration performance implications during the belonging bear and bull phases. By applying system GMM estimation on a panel dataset, consisting of 105 firms in the IT industry over the period 2007-2010, we find four results. An inverted U-shaped relationship is established between the exploitation-exploration ratio and firm performance in the bear and bull phases. This implies that firms that focus on both exploitation-exploration will outperform those firms that focus on either exploration or exploitation during both the bear and bull phase. Second, this relationship is positively moderated by the phase of the business cycle (i.e., bull phase); meaning that the performance implications of the exploitation-exploration ratio are more positive in a bull phase than in a bear phase. Third, the relative importance of balancing exploitation-exploration activities is greater in the bear phase than in the bull phase. As such, deviating from the most optimal exploitation-exploration ratio during a bear phase has, relatively, larger negative consequences than a similar deviation during a bull phase. Moreover, the optimal exploitation-exploration ratio changes, at large, toward more exploitation when moving from the bear to the bull phase. This means that, during a bear phase, more explorative investments are needed for optimal firm performance compared to the subsequent bull phase. The main theoretical contribution of this chapter lies in identifying the change in the most profitable exploitation-exploration ratio given shifts in the macroeconomic conditions. Also, our findings provide important practical insights in how to ‘fight the bear’ and ‘ride the bull’. In particular, investing more in exploration in the bear phase than in the subsequent bull phase is a counter-intuitive, but successful strategy that is highly different from what many firms actually do in a recession. With respect to the former observation, the second study (chapter 3) focuses on why so many firms intuitively overemphasize exploitation efforts while facing environmental turbulence. Often, a cost reduction strategy is adopted, with damage control as the main goal. As the results from chapter 2 imply, this frequently reinforces the declining trend in performance, triggering a further focus on exploitation. This situation, in which investments in exploitation cause for even more investments in exploitation, is commonly referred to as the ‘success trap’. However, there is no real underlying rationale, or process theory, detailing the workings of this trap. It is merely known that a primary focus on exploitation in some cases works self-reinforcing, but it is not known how firms get trapped in the success trap. Previous studies have attributed the success trap to managerial incompetence and/or myopia. However, some management teams appear to adequately recognize the exploration need, as the result of environmental fluctuation, while not being able to bring about the required strategic (and organizational) change. As such, the second study of this dissertation, reported in Chapter 3, investigates how it is possible that top managers enhance their firm’s exploitation focus, when the need to explore in response to environmental change is evident. We draw on system dynamics modeling to investigate this phenomenon. By means of a case study, a simulation model is developed and then the behavior of the selected firm is replicated to uncover the underlying processes. As such, we develop a process theory underlying the success trap at the managerial level, coined the ‘suppression process’. The main theoretical contribution to the exploitation-exploration literature is this process theory, underlying the success trap, at the managerial level. This process theory describes and explains how the interplay between top managers, board members, and exploitation–exploration activities can trap a firm in the suppression of exploration. The suppression process unfolds over five periods (period A, B, C, D, and E): (A) Initially, the investment balance in exploitation and exploration is well aligned with the environmental context. That is, the focus on exploitation in a stable environmental context results in good financial performance. This causes the executive team to stick to the exploitative strategy and, as such, provides the initial foundation for the eventual success trap. (B) The exclusive focus on exploitation grows increasingly suboptimal as the environment starts to change. Managerial awareness of this change rises only slowly, due to inertial and myopic forces. (C) The consequent decline in performance, due to the lack of explorative investments, triggers a growing external pressure to exploit (from the company’s shareholders). That is, an enhanced focus on exploitation during the initial phase of an environmental change sometimes pays off in the short-term. (D) Subsequently, the executive team’s awareness to initiate exploration investments starts to grow and the external pressure to exploit declines. As such, the situation arises in which management is able to invest in exploration. However, the new strategic direction needs to cross organizational boundaries and layers. Such an adoption and implementation process may take too long during this phase. In turn, this is likely to decrease the financial performance and again increase the pressure to exploit. (E) Now, the board’s pressure to exploit is so substantial that exploration investments are completely abandoned. As such, the executive team has to respond to the ongoing environmental change by making even more exploitation investments. As such, the firm is now entirely caught in the success trap. Not much is known about how to counteract the suppression process (or the success trap) once initiated. Utilizing the formal model developed for the second study, the third research contribution (chapter 4) is an analysis of possible escape paths from the success trap. Here we extend the second study by identifying the critical intervention-conditions required to counteract the suppression process. As such, Chapter 4 deals with the question how to counteract the suppression process characterized by underinvestment in exploration. The results imply that every phase of the suppression process requires a different intervention approach, with a different probability of success, in order to effectively neutralize the threat imposed by the success trap. As such, the main contribution to the exploitation-exploration literature and practitioners is the identification of the target, timing, size and duration of interventions at the managerial and board level, which are required to restore a healthy exploitation-exploration balance. The study identified four intervention-phases which are denoted by 1, 2, 3, and 4 (respectively: ‘too early’, ‘early’, ‘timely’, and ‘too late’). (1) Interventions conducted at the ‘too early’ phase are characterized by very high opportunity costs because short-term opportunities remain unused. These costs can be so significant that they result in the firm becoming trapped in the success trap. Interestingly, the best strategy to avoid the success trap, as this stage, is to do nothing and let period A of the suppression process unfold. (2) The main difference with the first phase is that interventions conducted at the ‘early’ phase have increasingly higher chances of success. That is, adjustments to the exploitation-exploration balance at this point (at the end of period A of the suppression process) are characterized by initially high, but rapidly decreasing, opportunity costs and required intervention effort (note that in Chapter 4, the actual effort is denoted by ‘intervention size’). (3) The ‘timely’ phase is distinguished by very low opportunity costs and small intervention effort required to counteract the suppression process. This phase greatly overlaps with period B of the suppression process; the period in which the environmental change ensues. (4) Finally, interventions that are designed and executed ‘too late’ have little chance of being successful due to the unlikely large intervention effort required. Management and/or the board have been waiting too long with adjusting the firm to the external context. Nevertheless, most frame-breaking changes are postponed until this phase is reached (which actually begins early in period C of the suppression process). Firm survival then depends on drastic turnarounds, such as a stock market exit. The results incorporated in this chapter illustrate how difficult it is to counteract the suppression process. Moreover, what becomes evident from all three studies is the importance of explorative investments during times of crisis. More specifically, a deliberate balance needs to be maintained between exploitation and exploration, dependent on the environmental situation. As such, for sustained firm survival, a thoughtful collaboration between the executive board and the Board of Directors regarding the exploitation-exploration balance is needed. More specifically, there should be consensus at the top management level concerning resource allocation and timing in order to effectively act upon environmental opportunities and threats.
Original languageEnglish
QualificationDoctor of Philosophy
Awarding Institution
  • Industrial Engineering and Innovation Sciences
Supervisors/Advisors
  • Romme, A.G.L. (Sjoerd), Promotor
  • van Oorschot, Kim, Copromotor
Award date12 Jun 2012
Place of PublicationEindhoven
Publisher
Print ISBNs978-90-386-3173-8
DOIs
Publication statusPublished - 2012

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