What Disruptive Technology Can Teach Us About the Economy

Includes: AAPL, IBM
by: Ryan Avent

I’ve been enjoying Tim Lee’s posts discussing the introduction and impact of a disruptive technology. Let me quote some (a lot) of what he’s been writing:

The key characteristic of a disruptive technology is that at its introduction, it is markedly inferior to the then-dominant technology, as judged by the existing base of customers. A classic example is the microcomputer. When the first microcomputers were released in the late 1970s by Apple, Commodore, and others, they were inferior in almost every respect to the minicomputers and mainframes that then dominated the computer market. People bought microcomputers for one of two reasons: they couldn’t afford a minicomputer, or they had an application where the microcomputer’s unique advantages (i.e. smaller size) were a particular advantage.

It’s important to understand that the innovator’s dilemma is not that disruptive technologies are “so innovative” that incumbent firms can’t keep up with them. To the contrary, disruptive technologies are often relatively pedestrian from an engineering point of view. Minicomputer manufacturers would have had no difficulty entering the microcomputer market if they’d wanted to. Rather, the innovator’s dilemma is that incumbents find it extremely difficult to make disruptive technologies profitably.

He quotes Clayton Christensen:

A characteristic of each value network is a particular cost structure that firms within it must create if they are to provide the products and services in the priority their customers demand. Thus, as the disk drive makers became large and successful within their “home” value network, they developed a very specific economic character: tuning their levels of effort and expenses in research, development, sales, marketing, and administration to the needs of their customers and the challenges of their competitors. Gross margins tended to evolve in each value network to levels that enabled better disk drive makers to make money, given these costs of doing business.

In turn, this gave these companies a very specific model for improving profitability. Generally, they found it difficult to improve profitability by hacking out cost while steadfastly standing in their mainstream market: The research, development, marketing, and administrative costs they were incurring were critical toremaining competitive in their mainstream business. Moving upmarket toward higher-performance products that promised higher gross margins was usually a more straightforward path to profit improvement. Moving downmarket was anathema to that objective…

Four times between 1983 and 1995, DEC introduced lines of personal computers targeted at consumers, products that were technologically much simpler than DEC’s minicomputers. But four times it failed to build businesses in this value network that were perceived within the company as profitable. Fourt times it withdrew from the personal computer market. Why? DEC launched all four forays from within the mainstream company. For all the reasons so far recounted, even though executive-level decisions lay behind the move into the PC business, those who made the day-to-day resource allocation decisions in the company never saw the sense in investing the necessary money, time, and energy in low-margin products that their customers didn’t want. Higher-performance initiatives that promised upscale margins, such as DEC’s super-fast Alpha microprocessor and its adventure into mainframe computers, captured the resources instead.

Now, here’s Lee again:

But companies aren’t big people, and it’s a mistake to think of them that way. In 1983, any given engineer at DEC could have easily quit his job making minicomputers and taken a job at Apple (NASDAQ:AAPL) or IBM (NYSE:IBM) making microcomputers. But it would have been much harder for DEC as an institution to make that same transition. Turning DEC into a microcomputer company would have required a wrenching, years-long struggle to essentially build a new company from the ground up. Indeed, as Christensen documents, the few firms that have successfully pulled off such a transition have done it by essentially growing a new company inside the existing one: senior management would start a subsidiary devoted to the disruptive technology and keep it insulated from the parent company’s managerial structure. The hope was that by the time the parent company fell on hard times, the subsidiary would hopefully have grown enough to sustain the overal company’s profitability. There are a few examples of this strategy working, but it’s an extremely risky and difficult process.

Me being me, I read this and instantly began thinking about cities. One of the things I’ve been puzzling over recently is the implosion of formerly successful metropolitan areas. In theory, there’s no reason why the decline of one of a city’s principle industries should lead to the decline of the city itself; cities have useful infrastructure, institutions, and human capital, and the decline of one industry should free up space that can be utilized by a new, growing industry.

In practice, things tend not to work out this way. Cities that face the loss of one of their main industries tend to suffer through a long period of decline before recovering, if in fact they manage to recover at all. Why is this? Why should all of the many things that go into the making of city come undone in one place just because one particular business failed, while all of the things that go into the making of a city are rebuilt from nothing elsewhere in the country? It makes no sense.

I have tended to focus on negative feedback loops as a primary explanation for this dynamic, and I feel certain they play an important role. Loss of part of a city’s tax base will lead to reductions in the quality of services and increasing tax rates, which will lead richer households to leave, further shrinking the tax base. Declining services lead to failing schools and high crime rates which accelerate depopulation and so on. A city’s most talented workers will have the most opportunity available elsewhere, and so they’ll be the first to leave, sharply reducing an area’s competitive attraction, thereby encouraging further talent to leave, and so on.

Ed Glaeser has argued that it’s very difficult to recover from depopulation because of the durability of the housing stock. Falling population alongside steady housing supply leads to falling home prices. This, in turn, attracts those who require cheap housing — the poor — which will further degrade housing values and attract more poverty. An increasing population of poor residents will also tax city services which will further imperil budgets, and so on.

That certainly seems like enough to destroy a city, but it isn’t. In real life, cities experience negative shocks all the time, but they don’t always enter into a major downward spiral. And some cities which do face a downward spiral manage to pull themselves out of it and enjoy an economic renaissance. Why?

I think Lee’s disruptive technology post offers us a glimpse at an explanation. When a metropolitan area has an old, successful, established industry as its economic driver, that area builds its infrastructure and institutions around that industry. These institutions are likely to be unwilling and unable to accomodate and support growth industries. We can think about legislators in a Rust Belt state who fight to protect old industries even when the protections they seek would undermine growth industries. Or banks in old manufacturing centers that are reluctant to invest in start-ups with sharply different practices from the old giants.

If you have a daring new idea, you don’t take it to someone who’s living fat off something which has worked for decades. You take it to someone who is hungry. Many of the Sunbelt boom towns which have sprung up over the past half century grew at the start by accepting what investment they could. I’m reminded of my hometown, where leaders were anxious to attract high-tech investments to their new Research Triangle Park. It was lack of better options that gave them the idea in the first place — something which might not have occured to leaders in a city where hundreds of thousands of people earned good union wages in manufacturing plants. And while leaders definitely wanted to craft a research environment, they took the investments they could get. Not having recently been on top of the world, they had the benefit of not suffering from wounded pride when less-than-glamorous operations came to invest.

And I think there’s something to the idea that new growth cities aren’t inherently superior to older, richer metropolitan areas. Rather, their advantages are fairly mundane — they’re cheap, accommodating, and ready to please. On the other hand, older, richer cities don’t realize that they have a problem until it’s clear their bread and butter industry won’t ever be the same, at which point they’re faced with serious problems and have few resources to attract new industries. At that point, there are few routes to recovery. A city might get lucky (by, say, enjoying proximity to another metropolitan area which enjoys a booming economy). It might manage to retain enough in the way of resources from niche industries, like tourism, to maintain a framework capable to supporting a new growth industry. Or it might find that one of its older and smaller industries is capable of growing large enough to fill in the missing economic strength.

There are tricky implications to this. It suggests, for instance, that the availability of new metropolitan areas is crucial in maintaining a flexible, growing economy. That creative destruction doesn’t just mean the scrapping of once-proud firms but of whole cities. It also suggests that my previous prescription for fighting urban decline — a program of temporary fiscal support — could be counterproductive. It might delay inevitable economic adjustments.

I don’t know that I accept that it’s necessary to destroy old cities and create new ones to keep an economy fresh. Revolutionary geography could be interchangeable with institutional or political revolution. That is, places that are less flexible geographically might instead face increased pressure to change institutions or otherwise accommodate disruptive economic change. Still, this seems to be an important part of the story of urban decline.