The Essence of Capitalism

There’s a misconception about innovation and new technology, where the destructive elements are seen as some sort of unwanted side effect. But it isn’t a side effect and it isn’t unwanted. On the contrary, the destructive quality is why we need endless innovation. Schumpeter’s creative destruction teaches us that innovation, new technology and new business models lead to the demise of less efficient products and industries. The endless process of replacing the old with something better paves the way for economic growth. 

As Clayton Christensen explained in The Innovators Dilemma, we have sustaining and disruptive innovations. We need both but it is disruptive innovations that have creative destruction at their very heart. 

Disruptive innovation starts with an entrepreneur developing a new product, which in turn leads to company formation and then grows into a new industry. This improves economic outcomes, increases choice and reduces prices for customers.

The birth of a new industry provides opportunities for yet more new products and yet more entrepreneurs to build more products. The effect of innovation and new technology is multiplicative. The growth continues. That’s why once an economy is behind, it takes an almighty effort to catch up unless the economic leaders make fatal mistakes. 

Along the way, the development of new technology and new business models doesn’t just destroy existing technology and models as some sort of unwanted side effect; it is the driver of the creative and destructive cycle which propels the world forward. It’s the very essence of capitalism. Clearing out the old and replacing it with new, continuous change is essential for long term progress. The zenith of the capitalist economy is creative destruction.

Once the internet was created, entrepreneurs created ecommerce, like Jeff Bezos and Amazon, which disrupted Borders. Later, AWS disrupted on-prem computing. Netflix came along and disrupted Blockbuster. Apple entered the phone business and disrupted Nokia and Blackberry with the iPhone. Thanks to the iPhone and the App Store, along came Uber and Grab, disrupting the taxi industry. The shipping container disrupted the union-backed stevedores. Napster, iTunes and, latterly, Spotify came along and disrupted the music industry and the previously impenetrable record labels. To borrow a cliche, the car disrupted the horse industry.

The disruption may not be quick. It can be quite slow. Lithium ion batteries have been disrupting the combustion engine and incumbent car manufacturers for a decade, with Tesla, BYD and others gaining market share.

As an existing industry matures, only those business models with margins that produce a profit survive. This inevitably means that an industry becomes more concentrated and increasingly moves towards an oligopoly, duopoly or monopoly as time passes. In most (but not all) cases, this is a bad outcome: competition generally is good. Only through innovation can incumbent businesses be disrupted and replaced with something better. But even then, it can be difficult, with financial, knowledge and reputation barriers to entry fortifying an incumbent’s position. If you want to disrupt the global financial messaging network, you must disrupt SWIFT. If you want to disrupt the world of payment processing, you will have to disrupt Mastercard and Visa. If you want to disrupt the world of soft drinks, you’re up against Coca-Cola. That’s a challenge. But it’s not impossible. Google (with Chrome) displaced Microsoft (with Explorer) in the browser wars, and then became the dominant market leader. But now generative AI startups are disrupting Google Search.

Recessions and periods of economic distress have first order effects of removing firms which are inefficient or financially unstable, but they also have second order effects of eliminating existing barriers to entry and are fertile times for new business models.

But by far, the most formidable opponents to come up again are nationalised industries and subsidised incumbents; the failing companies bailed out by the government. 

The equilibrium of supply and demand to determine a market price is the feedback loop that leads to the success and failure of businesses.

For any short-term gain for customers that comes from propping up a failing industry, the long-term harm of preventing the seeds of multiplicative growth that new companies, products, and industries bring is an order of magnitude larger. It prevents new ideas, products, businesses and industries from taking hold and prevents natural market evolution, embedding inefficient incumbents in a market dominant position. Incumbents must be faced with a choice: evolve or die; regulators must prioritise fair competition above all else, and economic systems must reward innovation, or we will get stasis.