Disruption. You can’t read a book about the tech industry without Clayton Christensen’s Innovator’s Dilemma coming up. Jobs loved it. Bezos loved it. Economists – well, they were a bit more confused. Here’s the story at its most elemental: in many industries, radical technologies are introduced. They perform very poorly initially, and so are ignored by the incumbent. These technologies rapidly improve, however, and the previously ignored entrants go on to dominate the industry. The lesson many tech industry folks take from this is that you ought to “disrupt yourself”. If there is a technology that can harm your most profitable business, then you should be the one to develop it; take Amazon’s “Lab126” Kindle skunkworks as an example.
There are a couple problems with this strategy, however (well, many problems actually, but I’ll save the rest for Jill Lepore’s harsh but lucid takedown of the disruption concept which recently made waves in the New Yorker). First, it simply isn’t true that all innovative industries are swept by “gales of creative destruction” – consider automobiles or pharma or oil, where the major players are essentially all quite old. Gans, Hsu and Scott Stern pointed out in a RAND article many years ago that if the market for ideas worked well, you would expect entrants with good ideas to just sell to incumbents, since the total surplus would be higher (less duplication of sales assets and the like) and since rents captured by the incumbent would be higher (less product market competition). That is, there’s no particular reason that highly innovative industries require constant churn of industry leaders.
The second problem concerns disrupting oneself or waiting to see which technologies will last. Imagine it is costly to investigate potentially disruptive technologies for the incumbent. For instance, selling mp3s in 2002 would have cannibalized existing CD sales at a retailer with a large existing CD business. Early on, the potentially disruptive technology isn’t “that good”, hence it is not in and of itself that profitable. Eventually, some of these potentially disruptive technologies will reveal themselves to actually be great improvements on the status quo. If that is the case, then, why not just let the entrant make these improvements/drive down costs/learn about market demand, and then buy them once they reveal that the potentially disruptive product is actually great? Presumably the incumbent even by this time still retains its initial advantage in logistics, sales, brand, etc. By waiting and buying instead of disrupting yourself, you can still earn those high profits on the CD business in 2002 even if mp3s had turned out to be a flash in the pan.
This is roughly the intuition in a new paper by Matt Marx – you may know his work on non-compete agreements – Gans and Hsu. Matt has also collected a great dataset from industry journals on every firm that ever operated in automated speech recognition. Using this data, the authors show that a policy by entrants of initial competition followed by licensing or acquisition is particularly common when the entrants come in with a “disruptive technology”. You should see these strategies, where the entrant proves the value of their technology and the incumbent waits to acquire, in industries where ideas are not terribly appropriable (why buy if you can steal?) and entry is not terribly expensive (in an area like biotech, clinical trials and the like are too expensive for very small firms). I would add that you also need complementary assets to be relatively hard to replicate; if they aren’t, the incumbent may well wind up being acquired rather than the entrant should the new technology prove successful!
Final July 2014 working paper (RePEc IDEAS). The paper is forthcoming in Management Science.
A Fine Theorem 