Disruptive Technology &
Legislative Oversight

Disruptive innovation is “an innovation that helps create a new market and value network and eventually disrupts an existing market and value network, thereby displacing an earlier technology.” Rory McDonald, PhD, described how industries are disrupted by new technologies and examined applications to processes of state government.

Across business history, from computers to retail to steel, leading companies failed to stay atop their markets. Well-managed firms noted for great performance missed something important that, in turn, led to their downfall. Common explanations usually cite managerial incompetence or technological complexity. But studies at Harvard Business School (HBS) led to a very different framework explaining failure of leading firms when confronted by certain types of market and/or technology change, that is, disruptive innovations. Dr. McDonald differentiated between sustaining innovations and disruptive innovations.

Sustaining Innovations

Well-managed firms can adapt to sustaining innovations, which improve products and services along dimensions of performance that mainstream existing customers care about. Existing customers and established profit models constrain firms’ investments in innovations. Incumbents are typically not motivated to pursue disruptive innovations that promise lower margins and target smaller markets. Sustaining innovations enable firms to sell more products to their best existing customers at higher margins and higher profitability. Every market finds performance improvements that existing customers can utilize, for example, improving the microprocessor speed of computers. Following the pace of technological progress, incumbents offer better-performing products and services, eventually overshooting the market. When sustaining innovations emerge, incumbents nearly always win.

Disruptive Innovations

Disruptive Innovation happens when the pace of technological progress outstrips markets’ demand for higher-performing technologies. Firms can over-serve the market by producing more advanced, feature-rich products than customers really need—leaving a gap at lower tiers of the market. New entrants almost always win with a disruptive innovation—one that does not improve performance but introduces a unique mix of attributes. Disruptive innovations are initially inferior on the historic performance dimensions, but offer a novel combination of attributes that appeal to fringe customers, offering low-end, new applications. They may be smaller, cheaper, more accessible, or more convenient. Margins may be less, but smaller, more adventurous companies are willing and able to take the risk to create a new market.

Low-End Disruptions: Lessons from Steel

Based on their research, Harvard Business School (HBS) developed the Disruptive Innovation Model. Dr. McDonald described this model using illustrations from the steel and video industries. Like many markets, the steel market is comprised of tiers with low-margin, concrete-reinforcing bar (rebar) at the bottom and high-margin structural sheet metal at the top. Integrated mills were making a full range of these products, but mini-mills could only make low-quality steel (rebar), but at a lower cost. The disruptive innovation adopted by mini-mills applied to the low-end segment of steel industry (rebar). As mini mills captured the low-margin, low-end rebar market, the integrated steel companies were pleased to get out. While the integrated steel companies sacrificed their lowest profit product line, their profitability actually improved. They had no incentive to develop mini-mills or compete with them.

In 1979, mini-mills finally drove the last integrated manufacturer entirely out of the rebar market. Then the price of rebar collapsed by 20%. Competition drove prices down so rebar was not profitable. So mini-mills locked up-market, and improving technology allowed them to move into the angle iron, bar, and rod markets. With the same result: integrated mills got out of the business, their profits improved, and mini-mills captured more market share. But the process can’t continue forever. Eventually, mini-mills were making high-quality structural steel at a price point that drove the integrated manufacturers out of the market. Today in the US, mini-mills account for between 60% and 65% of the entire steel market. All but one of the integrated steel companies have gone bankrupt.

Disruption in the Video Market

Dr. McDonald traced the trajectory of Blockbuster Video from market leader to ultimate closure, contrasting its course with that of Netflix. Blockbuster recognized that movie rentals were impulse decisions, customers wanted a new release for movie night, and 70% of the US population lived within a 10-minute drive of the 5,000 Blockbuster stores. And Blockbuster made 10% of their revenue from late fees.

Enter Netflix. In the late 1990s, Netflix launched home delivery of DVDs through the mail using the US Postal Service. They had a website on which you could create a queue of movies that you would receive in 3-5 days. This didn’t appeal to Blockbuster’s impulse buyers, but appealed to some fringe customers: Early adopters of DVD players, lesser known/indie film aficionados, geographically isolated, prefer shopping online vs. in stores. But as Netflix honed operations and technologies quickly improved over time, they were more attractive to mainstream consumers. They held a less expensive virtual national inventory and charged no late fees. They improved until they could offer convenience, value, and selection better than Blockbuster. Blockbuster, with its expensive inventory of first-run films, late fees, and brick-and-mortar stores, could not compete.

Disruptive Innovation Model

New-Market Disruptions

The steel and video examples illustrate low-end disruptions, which come in at the bottom of the market and take hold within an existing value network before moving up-market and attacking incumbents.

With new-market disruptions, entrants are creating and competing in entirely new markets. These innovations take hold in a different value network and compete against “non-consumption.” There are no existing customers who have used prior generation. The innovation satisfies a need in the market, but people do not adopt it because they cannot afford it. When someone makes the innovation affordable and accessible, then it competes against non-consumption.

Dr. McDonald reviewed examples of new-market disruptions across numerous industries, from Uber, which is transforming the taxi industry through ride-sharing, and Airbnb, which takes bites out of hotel market share by home-sharing. Both are dependent on Internet-based technologies to match potential customers with dispersed providers.

Minit-Clinics are disrupting the healthcare industry, Dr. McDonald pointed out, not by doing it better along traditional dimensions, but by doing it differently. In these clinics, whose motto is “You’re Sick, We’re quick,” a nurse practitioner can diagnose one of 20 everyday conditions in less than 15 minutes. If you have one of those conditions, it’s very quick, it’s very simple. You get your prescription on the spot.

Even accounting and financial services are subject to new-market disruptions as high-reliability apps are released based on algorithms that perform functions that once required professional interventions. They perform well enough for some customers.

Online colleges and free online courses may disrupt even elite schools like Harvard University, Dr. McDonald reported.

Implications for State Government

Because disruptive innovations start off in the fringe before moving to the mainstream, they often catch incumbents off-guard. But they can also have a similar effect on governments. For example, governments did not anticipate the political fall-out from the uproar caused by Uber, nor the security issues associated with Airbnb.

Uber now operates in 60 countries, 340 cities, employs 4,000 employees (drivers are contractors, not employees) and is valued at ~$50B—greater than at least 3/4 of the Fortune 500 companies, including General Mills, Delta, and Sony. Importantly for state senate leaders, they have ~250 lobbyists and 29 lobbying firms registered in state capitals across the nation. Uber’s strategy was to become embedded quickly in a city so that they were “too big to be banned.” The challenge for state leaders is how to identify disruptive innovations that have social and collective impacts before they become “too big to ban.” Policymakers must have more traction to shape and manage regulations on innovations earlier in the process.

In some new-market innovations, the desire for early entry and fast growth may outweigh consideration of legal risks. Competitive pressures may push innovative companies to ignore rules and violate laws. For example, video sites were vying for video content and viewers. YouTube adopted a lax copyright policy so that they could get big faster and become an acquisition target (Edelman, 2015). They removed the “report copyrighted content” button after users began reporting thousands of unauthorized videos because removing illegal content reduced video views by 80% or more. Competitors diligently screened each new video for copyright protection, giving YouTube a competitive advantage.

By embracing rule breakers, politicians appear forward-thinking, innovation-friendly, and challenging to established interests. But it also may create moral hazard issues, Dr. McDonald pointed out, quoting Professor Ben Edelman: “If we let tech companies launch first and ask questions later, we invite misbehavior of exactly this type… If we let a few firms ignore the rules, we effectively penalize those that comply with the law, while granting windfalls to free-wheeling competitors.”

Firms facing regulatory barriers can seek new-market segments where barriers do not apply and then leverage disruptive innovation principles. As firms improve and serve broader segments, customer demand may eventually spur regulatory changes. This approach may have a higher change of success than direct attempts to force regulatory change, Dr. McDonald concluded.

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Discussion

Sen. Ronald Kouchi (HI): Some high-end hotel chains are also creating lower-end brands and taking market-share from the low end.

Dr. McDonald: The biggest disruptions come when technology enables entirely new strategies. For example, in early Airbnb offerings, you could book a room in someone’s apartment or on their couch. Now, they have moved up-market and you can book a palatial estate.

Sen. Debby Barrett (MT): How are newspapers surviving as communications technology advances?

Dr. McDonald: Online sites like Craig’s List cannibalized advertising revenue, and more and more people look to sites like Buzz Feed for aggregated news. Big publishing companies cannot suddenly go digital because their margins are lower and a different business model is needed. Large companies are more likely to spin off a start up digital operation where lower margins are acceptable.

Sen. Tom Apodaca (NC): A concern for legislators is how we can replace the tax revenues that we lose to online services like Airbnb or Uber. How do we deal with revenue loss?

Dr. McDonald: Disruptive technologies start on the fringes. They don’t attract attention from the state leaders until they are big enough to cause existing competitors to complain. It’s essential for state leaders to have staff that can pay attention to innovators when they are small and new, when you can negotiate with them to mitigate the impact on your revenues. As technology advances, some revenue streams will dry up, but at the same time some inspections, some permits, and other state-funded activities become unnecessary, so states can reallocate resources from no-longer-needed services to other activities.

Sen. Teresa Paiva Weed (RI): Rhode Island relies on the hotel and taxi taxes from tourism. We had to educate ourselves about what online services offer and understand their collection process in order to propose tax-collection plans that would work. Both Airbnb and Uber agreed to collect taxes in our state, which allows us to level the playing field and also to sustain our revenue.

Sen. Hugh Leatherman (SC): Senate leaders need to be able to foresee what is the up-and-coming innovation. We want to manage the relationship while the innovators are small. It is helpful to see how other states are managing these innovations. We need to have staff who are technically expert enough to track these advances.

Sen. Kevin Meyer (AK): Disruptive technologies could enable government to provide better services at lower cost; for example, we wanted to use video monitoring instead of traffic officers for traffic violations. But the public resisted this.

Sen. Jonathan Dismang (OK): As legislators, we face disruption all the time. The less powerful party will get innovative and use cheap social media to make their points and start to gain market share. This is what the Tea Party has done. The established party in power becomes complacent and gets too comfortable.

Sen. David Givens (KY): If we look at the Senate leader’s role as producing policy for public administration, our customers are our constituents. The problem is that they change their minds all the time. How do I predict what services they will want or what disruptive technologies they are likely to adopt? How do we avoid constant disruption so we don’t become unproductive?

Dr. McDonald: You can start by identifying a stable set of state-oriented “jobs” that constituents want to get done, such as registering a car, getting home-remodeling construction approved, and having fire or sanitation services. What can you offer to give constituents more selection, lower prices, or faster delivery on getting those jobs done? We have a lot of great data about the past – but the future may be different.

Sen. Wayne Neiderhauser (UT): Policy-making can be subject to innovative technology disruption, as we saw with the Uber example. Elections, too, have disruptive technologies affecting them, for example, though technical manipulation of voting. While we want to protect sensitive activities from disruption, we also should be looking at disruption in a positive way. We have to think about what innovations would be good for our constituents down the road, and how we can facilitate those advances so that we are not disrupted.

Speaker Biographies

Rory McDonald

Rory McDonald is an Assistant Professor of Business Administration in the Technology and Operations Management Unit. He teaches the Technology and Operations Management course in the MBA required curriculum.

Professor McDonald’s research focuses on how firms innovate effectively in new technology-enabled markets. Drawing on in-depth fieldwork and archival data, he studies how executives develop viable strategies in these contexts and how they obtain resources that improve their chances of success. For his research on Internet companies, Rory received a Kauffman Foundation Fellowship in Entrepreneurship and was a finalist for best dissertation in Business Policy and Strategy by the Academy of Management.

Professor McDonald received his PhD in Management Science and Engineering from the Stanford Technology Ventures Program. He also holds an MBA and an MA in economic sociology from Stanford as well as two engineering degrees from the University of South Florida. Before joining Harvard, he was on the faculty of the University of Texas at Austin where he received the CBA Foundation Teaching award. Rory is on the board of YCG Funds, an Austin-based mutual fund company, and is an advisor to several startups.

Rory and his wife Anne live in Sudbury, MA with their four children. They are active in their church and enjoy a variety of family activities.

Other New Media & Government articles:

Rory McDonald

Assistant Professor of
Business Administration

Harvard Business School

Harvard University

 

Across business history, leading companies failed to stay atop their markets. Well-managed firms noted for great performance missed something important that, in turn, led to their downfall.

Disruptive Innovation happens when the pace of technological progress outstrips markets’ demand for higher-performing technologies.

Today in the US, mini-mills account for between 60% and 65% of entire steel market. All but one of the integrated steel companies have gone bankrupt.

Netflix honed operations and technologies improved rapidly. Compared to Blockbuster, Netflix held a less expensive virtual national inventory and charged no late fees. They improved until they could offer convenience, value, and a selection better than that offered by Blockbuster.

With new-market disruptions, entrants are creating and competing in entirely new markets. These innovations take hold in a different value network and compete against “non-consumption.”

Competitive pressures may push innovative companies to ignore rules and violate laws.

The challenge for state leaders is how to identify disruptive innovations early enough to shape and manage regulations before the innovators become too big to regulate.

“If we let tech companies launch first and ask questions later, we invite misbehavior… If we let a few firms ignore the rules, we effectively penalize those that comply with the law, while granting windfalls to free-wheeling competitors.”

-- Professor Ben Edelman

Sen. Debby Barrett

Sen. Tom Apodaca

Sen. Teresa Paiva Weed

Sen. Hugh Leatherman

Sen. Kevin Meyer

Sen. Jonathan Dismang

Sen. Wayne Neiderhauser

Rory McDonald

Senate Presidents’ Forum

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