Capability Building in Sluggish Organizations

In order to thrive, organizations need to build and maintain an ability to meet unexpected external challenges. Yet many organizations are sluggish: their capabilities can only undergo incremental changes over time. What are the stochastic processes governing “routinely occurring” challenges that best prepare a sluggish organization for unexpected challenges? We address this question with a stylized principal-agent model. The “agent” represents a sluggish organization that can only change its capability by one unit at a time, and the “principal” represents the organization’s head or its competitive environment. The principal commits ex ante to a Markov process over challenge levels. We characterize the process that maximizes long-run capability for both myopic and arbitrarily patient agents. We show how stochastic, time-varying challenges dramatically improve a sluggish organization’s preparedness for sudden challenges. This paper was accepted by Joshua Gans, business strategy.